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December 20, 2017
2017-2168

Tax reform conference bill contains provisions affecting individual taxpayers

The Conference Agreement on the Tax Cuts and Jobs Act (H.R. 1) unveiled by the conference committee on December 15, 2017, is intended to overhaul America's tax code to deliver historic tax relief for workers, families and job creators, and revitalize our nation's economy.

The Committee states that, by lowering taxes across the board, eliminating costly special-interest tax breaks, and modernizing our international tax system, the Tax Cuts and Jobs Act will help create more jobs, increase paychecks, and make the tax code simpler and fairer for Americans of all walks of life. However, some of these provisions are so complicated that it will likely take years for taxpayers and the IRS to understand how they should actually work.

Individual and estate/trust provisions

Reduction and simplification of individual income tax rates

Current law

Seven individual federal income tax brackets apply for tax year 2017: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The applicable tax bracket for an individual taxpayer depends upon the person's filing status and income level, as follows:

 

Married filing jointly (MFJ)

Head of Household (HoH)

Single

Estate & trust

10%

<$18.650

<$13,350

<$9,325

N/A

15%

<$75,900

<$50,800

<$37,950

<$2,550

25%

<$153,100

<$131,200

<$91,900

<$9,150

28%

<$233,350

<$212,500

<$191,650

N/A

33%

<$416,700

<$416,700

<$416,700

N/A

35%

<$470,700

<$444,500

<$418,400

<$12,500

39.6%

>$470,700

>$444,500

>$418,400

>$12,500

In addition, current law taxes net long-term capital gain and qualified dividend income (QDI) at either 0%, 10% or 15%, depending on the ordinary income tax bracket of the taxpayer:

0% capital gains rate

Taxpayers in the 10% or 15% rate brackets

15% capital gains rate

Taxpayers in the 25%, 28%, 33% or 35% tax brackets

20% capital gains rate

Taxpayers in the 39.6% rate bracket

Provision

The provision would temporarily replace the existing rate structure with a new rate structure:

 

Married filing jointly (MFJ)

Head of Household (HoH)

Single

Married filing separately

Estate & trust

10%

<$19,050

<$13,600

<$9,525

<$9,525

<$2,550

12%

<$77,400

<$51,800

<$38,700

<$38,700

N/A

22%

<$165,000

<$82,500

<$82,500

<$82,500

N/A

24%

<$315,000

<$157,500

<$157,500

<$157,500

<$9,150

32%

<$400,000

<$200,000

<$200,000

<$200,000

N/A

35%

<$600,000

<$500,000

<$500,000

<$300,000

<$12,500

37%

>$600,000

>$500,000

>$500,000

>$300,000

>$12,500

The Conference Agreement:

— Does not phase out the benefit of the 12% bracket for taxpayers with adjusted gross income (AGI) over $1 million ($1.2 million for married taxpayers filing jointly) as was provided in the House bill

— Generally retains present-law maximum rates on net capital gains and qualified dividends

— Simplifies the "kiddie tax" up to tax years beginning before December 31, 2025

— Directs the Treasury Secretary to promulgate due diligence requirements for paid preparers to use in determining whether a taxpayer is eligible to file as head of household

Effective date

The provision would apply for tax years beginning after December 31, 2017, and not apply for tax years beginning after December 31, 2025.

Implications

The seven-bracket system provides a slower increase in progressivity of the individual provisions. In other words, an individual with an income of $X will be taxed at a somewhat lower rate under the proposed rate plan than the individual would be under the current rate plan, but would also have fewer deductions to claim.

The IRS has stated publicly that when these new rate tables are combined with the new standard deduction amounts, taxpayers should see the amounts withheld from their wages go down as early as February.

Married couples remain on par with two single taxpayers as income rises to the $400,000 level, but after this point the "marriage penalty" reenters the calculation as a married couple reach the 35% and 37% bracket faster than two single taxpayers.

Alternative inflation adjustment

Current law

Under current law, certain individual income tax amounts are adjusted based on annual changes in the Consumer Price Index for All Urban Consumers (CPI-U), including the: regular income tax brackets, basic standard deduction, additional standard deduction for aged and blind, personal exemption amount, thresholds for overall limitation on itemized deductions and personal exemption phase-out, IRA contributions limits and deductible amounts, and saver's credit.

Provision

The provision would require indexing for inflation using the Chained Consumer Price Index (C-CPI) instead of the current CPI-U.

Effective date

The C-CPI indexing requirement would be permanent after 2017.

Implications

C-CPI takes into consideration substitutions 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-U.

Interestingly, the widely criticized December 11, 2017, Treasury report concluded that the bills "pay for themselves" by increased gross domestic product (GDP) growth. Ordinarily, increased GDP growth is accompanied with increased inflation. To the extent that a taxpayer's income growth increases with CPI-based inflation, the use of C-CPI will result in tax brackets rising slower than the income growth. As a result, taxpayers will see more of their income increases going to the government and their after-tax spending power being slowly eroded.

Increase in standard deduction and repeal of the deduction for personal exemptions

Current law

Under current law, adjusted gross income (AGI) is reduced by either the standard deduction or itemized deductions, if the taxpayer chooses to itemize. For the 2017 tax year, the standard deduction is:

— $6,350 for single individuals and married individuals filing separately
— $9,350 for heads of households
— $12,700 for married couples filing jointly

Current law allows a taxpayer to claim a personal exemption for the 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; heads-of-household beginning at $287,650; married couples filing jointly beginning at $313,800; and married taxpayers filing separately beginning at $150,000.

Provision

The provision would increase the standard deduction to:

— $24,000 for married couples filing jointly and surviving spouses
— $18,000 for single filers with at least one qualifying child
— $12,000 for all other taxpayers

The provision would suspend the personal exemption deduction for tax years beginning between January 1, 2018 and December 31, 2025. The Conference Agreement also provides that the Treasury Secretary may administer the Section 3402 withholding rules, without regard to amendments made by the provision, for tax years beginning before January 1, 2019. (Whether wage withholding rules remain unchanged for 2018 would be at the Treasury's discretion.)

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The increase in the standard deduction should simplify federal income tax filings for millions of taxpayers. This is one of the few areas of the Conference Agreement that can be said to simplify taxes for individuals. Of course, this simplification will only last through 2025. This may also help to mitigate the impact of the loss of deductions for real estate or state and local income taxes (discussed below) for taxpayers who currently itemize with total itemized deductions below this standard deduction.

Enhanced child tax credit and new family credit

Current law

Generally, a taxpayer may claim a $1,000 tax credit for each qualifying child who is younger than 17. A qualifying child must be a US citizen, national or resident. The aggregate amount of the credit that a taxpayer may claim is phased out for taxpayers with AGI above $75,000 for single taxpayers and heads of households, or above $110,000 for married couples filing jointly and $55,000 for married individuals filing separately. The credit may be claimed under the regular tax system and the alternative minimum tax (AMT).

Provision

The provision would temporarily increase the child tax credit to $2,000 per qualifying child, but retain the current-law age limit for a qualified child, permitting the credit to be claimed for each qualifying child who is younger than 17. The provision would also temporarily provide a $500 nonrefundable credit for qualifying dependents other than qualifying children. The maximum refundable amount of the credit would not exceed $1,400 per qualifying child. The Social Security number for each qualifying child must be provided on the tax return on which a credit is claimed.

The income level at which the credit begins to phase out would be $400,000 for married taxpayers filing jointly and $200,000 for all other taxpayers, not indexed by inflation.

Effective Date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The child tax credit was an important part of the individual bill provisions. The increase in the child tax credit was a necessary mechanism to keep middle income taxpayers from potentially seeing a tax increase when they switch from itemized deductions to the new elevated standard deduction. However, this also leads to a case where taxpayers without children may see their taxes increase under the bill because they don't have the credit offset.

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. For individual taxpayers, estates, and trusts the two AMT brackets are 26% (applied to the first $182,500 of AMT income) and 28% (applied to AMT income over $182,500).

Provision

The provision would temporarily increase both the exemption amount and exemption amount phase-out thresholds for the individual AMT. For tax years beginning between January 1, 2018 and December 31, 2025, the AMT exemption amount would be $109,400 for married taxpayers filing jointly, $54,700 for married taxpayers filing separately, and $70,300 for all other taxpayers (except trusts and estates). The phase-out threshold would be increased to $1 million for married taxpayers filing jointly and $500,000 for all other taxpayers, except trusts and estates.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The potential elimination of the AMT was going to be one of the crowning achievements of tax reform. The AMT has bedeviled Congress and taxpayers for generations. Just a few years ago, Congress bit the fiscal "bullet" and indexed the exclusions for inflation at great budgetary cost. But as we have seen, kicking the AMT habit is easier said than done. Well, sort of. Although the individual AMT is retained in its current form, the increases to the exemption and phase-out amounts would make it less likely for non-corporate taxpayers to owe AMT. Because the AMT will continue to exist, however, taxpayers will still need to compute it, which will continue to add complexity to their returns.

Repeal of overall limitation on itemized deductions

Current law

Current law limits the total amount of itemized deductions (except deductions for medical expenses, investment interest, and losses due to casualty, theft and wagering) for certain high-income taxpayers (Pease limitation). The Pease limitation applies in addition to any other applicable limitations (e.g., deductions) but may not reduce itemized deductions by more than 80%. For 2017, the thresholds at which the Pease limitation applied were: (1) $261,500 for single taxpayers; (2) $313,800 for married couples filing jointly and surviving spouses; (3) $287,650 for heads of households; and (4) $156,900 for married taxpayers filing separately.

Provision

The provision would repeal the overall limitation on itemized deductions.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The elimination of the so-called PEASE limitation is a reasonable accommodation to taxpayers when so many of their itemized deductions have been limited or eliminated by other provisions. The removal of this limitation is actually a simplifying provision for higher-income taxpayers. But, like many of the other provisions, it is effective for years 2018 through 2025.

Modification of deduction for home mortgage interest

Current law

Current law allows a taxpayer who chooses to itemize deductions to claim a deduction for interest paid on the mortgage for the taxpayer's principal residence and one other residence (second home). Mortgage deductions may be claimed on interest payments on up to $1 million in acquisition indebtedness and up to $100,000 in home equity indebtedness. Under the AMT, however, a taxpayer may not claim a home equity mortgage interest deduction.

Provision

For tax years beginning between January 1, 2018 and December 31, 2025, the provision would allow a taxpayer to treat up to $750,000 as acquisition indebtedness ($375,000 for married taxpayers filing separately). For tax years beginning after December 31, 2025, the provision would permit a taxpayer to treat up to $1 million ($500,000 for married taxpayers filing separately) as acquisition indebtedness, regardless of when the indebtedness is incurred.

The provision would also eliminate the deduction for interest on home equity loans for tax years beginning between January 1, 2018, and December 31, 2025 and would apply to mortgages entered into after December 15, 2017.

This provision does not apply to mortgages entered into on or before December 15, 2017 or to refinancing after such date, as long as the amount of the indebtedness resulting from the refinancing does not exceed the amount of the refinanced indebtedness.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

This provision is the first time that the mortgage interest deduction has changed since its reform in 1987. It will take some time for taxpayers who have a casual understanding of the rules to get used to these temporary provisions. The following examples will help illustrate the impact on common scenarios:

Example 1: Married taxpayers have a first mortgage of $1.5 million at 4% (interest only) that was acquired when they purchased their principal residence in 2013.

In 2017, the taxpayers paid $60,000 of interest. They are able to deduct $44,000 ($1,100,000 / $1,500,000 x $60,000). In 2018, the taxpayers pay $60,000 of interest. Under the provision, they will be able to deduct $40,000 ($1,000,000 / $1,500,000 x $60,000).

Example 2: Same facts as example 1, but they refinance the mortgage in 2019 for a 30-year term at a fixed 3.5%.

The original mortgage is grandfathered, so the refinanced mortgage will also be grandfathered, thus entitling them to deduct the 3.5% interest on the first $1 million.

Example 3: Married taxpayers have a first mortgage of $815,000 on a principal residence acquired in 2008. In 2016, they opened a home equity line of credit (HELOC) and used $75,000 to pay off student loans.

When computing their 2017 taxes, they were able to deduct on their Form 1040, Schedule A, interest on the first mortgage as acquisition indebtedness and interest on the $75,000 HELOC as mortgage interest.

When computing their 2018 taxes, they were able to deduct on their Form 1040, Schedule A, interest on the first mortgage as acquisition indebtedness, but could not deduct interest on the $75,000 HELOC as mortgage interest.

Example 4: Same facts as Example 3, but the taxpayers used the $75,000 HELOC to renovate their kitchen and bathrooms in their principal residence.

When computing their 2017 taxes, they were able to deduct interest on the first mortgage and HELOC as acquisition indebtedness on their Form 1040, Schedule A. Because the first mortgage and HELOC are considered acquisition indebtedness, the interest on the combined amount of $890,000 will continue to be deductible in 2018 and forward.

Example 5: Same facts as Example 3, but the taxpayers used the $75,000 HELOC to purchase new equipment in the taxpayer's landscaping business.

When computing their 2017 taxes, they were able to deduct interest on the first mortgage as acquisition indebtedness and interest on the $75,000 HELOC as mortgage interest on their Form 1040, Schedule A.

When computing their 2018 taxes, they are able to deduct interest on the first mortgage as acquisition indebtedness, but could not deduct interest on the $75,000 HELOC as mortgage interest on their Form 1040, Schedule A. However, because the HELOC is no longer considered mortgage interest, the use of the $75,000 proceeds is traced to the taxpayers' landscaping business. Therefore, it is possible that the interest will still be deductible as business interest expense.

Example 6: Married taxpayers have a first mortgage of $815,000 for a principal residence acquired in 2008. In 2019, they opened a HELOC and used $75,000 to renovate their kitchen and bathrooms in their principal residence.

In this case, the interest on the $815,000 is grandfathered. However, even though the $75,000 is acquisition indebtedness, the new limit of $750,000 for loans after 2017 has been met. Therefore, the interest on the HELOC is not deductible in 2019 (but will be in their tax years beginning after December 31, 2025).

Example 7: Same facts as Example 6, except that the first mortgage is only $600,000 when the HELOC is opened in 2019.

In this case, the interest on the $600,000 is grandfathered. But unlike Example 5, when the $75,000 of acquisition indebtedness is added to the $600,000, it is below the new limit of $750,000. Therefore, the interest on the combined amount of $675,000 will be deductible in 2019 and forward.

Finally, as a planning point, individuals with mortgages above the $750,000 threshold might consider the merits of refinancing their amortizing mortgage into an interest-only mortgage to preserve the deductibility.

Modification of deduction for taxes not paid or accrued in a trade or business

Current law

Current law allows taxpayers who itemize deductions to claim a deduction for state and local government income and property taxes paid during the tax year. Rather than deducting state and local income taxes, an itemizing taxpayer may choose to claim an itemized deduction for state and local sales taxes paid.

Provision

The provision would allow an individual taxpayer to claim a deduction for state, local or foreign property or sales taxes only when the taxes were paid or accrued in carrying on a trade or business or an activity described in Section 212 (expenses incurred for the production of income). The provision generally would eliminate the ability of an individual taxpayer to deduct his state or local income taxes, war profits or excess profits tax. One exception would be available under the provision, allowing a taxpayer to claim an itemized deduction of up to $10,000 ($5,000 if married filing separately) for the aggregate amount of state and local property tax, war profits, excess profits tax and income tax (or sales taxes). Additionally, individuals would generally continue to be able to deduct their distributive share of state and local property taxes allocable from a pass-through entity.

These rules would apply for tax years beginning after December 31, 2017, and before January 1, 2026.

The Conference Agreement provides that state or local income tax imposed for a tax year beginning after December 31, 2017, may not be prepaid and claimed as an itemized deduction for 2017.

Effective date

The provision would be effective for tax years beginning after December 31, 2016.

Implications

The $10,000 limit for the itemized deduction for taxes originated in the Senate and House bills, but was expanded to include personal property taxes, state and local income taxes or sales taxes. This was a reasonable accommodation by the conference committee because it provides parity between property owners and renters, as well as individuals residing in different states where governments use different funding mechanisms (rates of property tax and income tax) to generate operating revenue.

The provision also applies to limit the deduction for estates and trusts.

Similar to the other bills, these amendments would not affect the "non-income" tax liability of individuals (and, for example, partnerships and S corporations) conducting a trade or business or for-profit activity. It has been understood for several generations that the use of income as a measurement does not, however, necessarily make a tax an "income tax." In determining whether a tax is an "income tax" — for purposes of this proposed elimination — taxpayers should not simply look to whether income, either gross or net, is used as the measure of taxation; instead, taxpayers must look to the purpose and application of the tax at issue. In any event, it appears that state and local taxes that are non-itemized deductions, but yet are imposed on businesses and individuals (such as the New York City Unincorporated Business Tax and the Metropolitan Commuter Transportation Mobility Tax) would probably remain deductible because they never were taxes described in Section 164(a)(3).

However, following the Senate and House versions, state and local property tax associated with a business or for-profit activity would continue to be deductible on Schedules C, E or F. Additionally, property taxes that are associated with a non-rental real property held for investment would still be considered an investment activity and, thus, could still likely remain an itemized deduction.

Due to the severity of this provision on owners of passthrough businesses, it is likely that many businesses will evaluate whether operating as a C corporation may be more beneficial. Additionally, it would be perfectly rationale for some large operating passthrough businesses to inquire with state governments about changing the state income tax structure to replace income taxes imposed on the owners with an entity-level tax that would remain deductible.

In the weeks leading up to the release of the Conference Agreement, there was much discussion and planning around the possibility of pre-paying 2018 state and local taxes in December 2017 in order to deduct it on the 2017 income tax return. Unfortunately, the Conference Agreement text eliminated any ability to deduct pre-payments of 2018 state and local income taxes on the 2017 income tax returns of non-corporate taxpayers. However, the limitation only applies to income taxes; it does not apply to real estate or personal property taxes. As a result, it seems to reaffirm the proposition that cash-basis taxpayers can deduct payments (other than state and local income taxes) for reasonably estimated liabilities that are non-refundable and are proposed to be eliminated.

Modification to personal casualty losses

Current law

Current law allows a taxpayer who itemizes deductions generally to claim a deduction for any loss sustained during the tax year that is not compensated by insurance or otherwise. For individuals, deductible losses must be incurred in a profit-seeking activity or consist of property losses due to fire, storm, or other casualty or from theft, for amounts that exceed 10% of AGI.

Provision

The provision would limit deductions for personal casualty losses to those incurred in a disaster declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

This provision was contained in the House and Senate bills, but the statutory text in the Conference Agreement is more precise than the other two bills. The other provisions limited personal casualty and theft losses to areas in presidentially declared disaster areas. The policy logic was reasonable for casualty losses, but didn't make much sense for thefts. The Conference Agreement tightens up the language whereby casualty losses are allowed only if incurred in disaster areas, but the rules for thefts are left unchanged.

The consequence of the provision is that casualty events like house fires will no longer be deductible, but losses from many natural disasters like wildfires, earthquakes, floods, tornados and hurricanes will remain deductible. However, it will put pressure on the Administration with regards to "line drawing" when declaring disaster areas.

The other impact on casualty losses that is not readily apparent is the change to the net operating loss (NOL) rules. Another provision of the bill removes NOL carrybacks and limits carryforwards to only 80% of income each year. If an individual's casualty or theft loss is big enough, it can generate an NOL. One of the benefits of the NOL is that it was able to be carried back to prior years in order to get tax refunds. These refunds have a great impact because they generate immediate cash infusions that could be used to repair property and lives. But with the new NOL rules, such refunds will not be available.

Finally, unlike many of the other individual tax provisions in the bill, this one is permanent.

Limitation on wagering losses

Current law

Current law generally allows a taxpayer who itemizes to claim: (1) a deduction for gambling losses to the extent of the taxpayer's gambling winnings; and (2) certain other deductions connected to gambling.

Provision

The provision would clarify that the limitation on losses a taxpayer may claim from wagering applies not only to the costs that gamblers actually incur but also to other expenses that gamblers incur in connection with their gambling activities (e.g., hotel and travel expenses). The provision would not apply to tax years beginning after December 31, 2025.

Effective date

The provision would be effective for tax years beginning after 2017.

Implications

This provision really only impacts professional gamblers (Comm'r v. Groetzinger-types). It may have impacted non-business, for-profit gamblers as well, but their deductions were eliminated with the suspension of miscellaneous itemized deductions, so the universe of affected taxpayers is relatively small. But with the repeal of the itemized deductions for for-profit gamblers, coupled with states' continued relaxation of gambling laws, it is possible that the number of professional gamblers could grow between now and when the provision expires in 2026.

Modifications to the deduction for charitable contributions

Current law

Current law allows a taxpayer who itemizes deductions to claim deductions for charitable contributions made by the last day of the tax year. The deduction is limited to a certain percentage of the taxpayer's AGI, which varies depending on the type of property contributed and the type of tax-exempt organization to which the donation is made. Generally, deductions for contributions to public charities, private operating foundations, and some non-operating foundations are limited to 50% of the donor's AGI. Contributions to private foundations may be deducted up to the lesser of: (1) 30% of AGI; or (2) the amount by which the 50%-of-AGI limitation for the tax year exceeds the amount of charitable contributions subject to the 30% limitation.

Deductions of up to 30% of AGI may be claimed for capital gain property contributed to public charities, private operating foundations and certain non-operating private foundations. For donations of capital gain property to non-operating private foundations, deductions may be claimed for the lesser of: (1) 20% of AGI; or (2) the amount by which the 30%-of-AGI limitation exceeds the amount of property subject to the 30% limitation for contributions of capital gain property. Excess contributions may be carried over for up to five years (15 years for qualified conservation contributions).

Current law also allows a taxpayer to claim a deduction of 80% of the amount paid to colleges for athletic event seating rights.

To claim a charitable deduction for a contribution of $250 or more, the taxpayer generally must provide the IRS with a contemporaneous written acknowledgement by the donee organization. This requirement does not apply if the donee organization files a return with the required information.

Provision

The provision would increase the income-based percentage limit (Section 170(b)(1)(A)) from 50% to 60% on the total charitable contribution deduction an individual taxpayer may claim for certain charitable contributions of cash to public charities. This change would allow an individual taxpayer to claim a charitable contribution deduction for cash donations to charity totaling up to 60% of the taxpayer's AGI for the year. The provision would not apply to tax years beginning after December 31, 2025.

The provision also would eliminate the deduction for amounts paid for college seating rights and the exception to the contemporaneous written acknowledgement if the donee organization files a return with the required information.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The legislative text provides that the amendment shall apply to contributions in tax years beginning after December 31, 2017. As a consequence, it appears that it will only apply to cash contributions in 2018 and thereafter. Therefore, cash contributions that were made in 2017 or earlier and are carried forward into 2018 will retain their 50% AGI limitation.

The increased standard deduction will mean that millions of taxpayers will not receive an incremental benefit for their charitable gifting given the elimination of many itemized deductions and the cap on real estate taxes and home mortgage interest. In addition, the lower marginal rates for most taxpayers could mean that there is an opportunity to obtain a greater tax benefit in calendar year 2017, which may be lost or more limited in future years. Bunching of charitable gifts in one year, for example, into donor advised funds may be a way to increase such benefit.

The elimination of the deduction for college athletic event seating rights probably will not affect colleges that charge their season ticket holders for such rights, as there is no indication season ticket holders will refuse to pay for these rights. In general, to deduct a gift to a charity, the giving of the gift must be with charitable intent — it is debatable whether this intent exists regarding the purchases of tickets to gaming events.

Repeal of certain miscellaneous itemized deductions subject to the 2% floor

Current law

Under current law, individual taxpayers who itemize may claim deductions for certain miscellaneous expenses. Some of these expenses must exceed 2% of the taxpayer's AGI to be deductible, including:

— Expenses for the production or collection of income (investment expenses, etc.)

— Unreimbursed expenses attributable to the trade or business of being an employee

— Repayments of income received under a claim of right (only subject to the 2% floor if less than $3,000)

— Repayments of Social Security benefits

— Shares of deductible investment expenses from pass-through entities

Provision

The provision would suspend all miscellaneous itemized deductions subject to the 2% floor under current law, and would not apply to tax years beginning after December 31, 2025.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The difficulty with this provision is that the Conference Agreement proposes to eliminate a provision that defines its scope by exclusion. In other words, it proposes to eliminate every deduction for individuals in the entire Code that is not specifically identified in Section 62 as an above-the-line expense and not specifically identified in Section 67(b). Given that the definition is one of exclusion, it is hard to know the provision's exact scope. The conference report gives some examples, but those are just the most common.

Regardless of the unknown expanse of the deduction-cutting for individuals, expenses that are not commonly or customarily incurred by individuals remain deductible for estates and trusts. These expenses include: probate court fees and costs; fiduciary bond premiums; legal publication costs of notices to creditors or heirs; the cost of certified copies of the decedent's death certificate; and costs related to fiduciary accounts. Additionally, certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor remain deductible. In all likelihood, attorney and accountant fees should remain deductible because they are not miscellaneous itemized deductions for estates and trusts.

Modification to the deduction for medical expenses

Current law

Current law allows a taxpayer who itemizes deductions to claim an itemized deduction for out-of-pocket medical expenses for the taxpayer, a spouse and dependents to the extent the expenses exceed 10% of the taxpayer's AGI.

Provision

The provision would establish a 7.5% threshold for deducting medical expenses for tax years beginning after December 31, 2016 and ending before January 1, 2019, both for regular tax and AMT purposes.

Effective date

The provision is effective for tax years beginning after December 31, 2016.

Implications

This provision follows the Senate bill. The House bill proposed to eliminate the deduction entirely. Of all the differences in bill provisions between the Senate and House, this one could be said to be the starkest. The 10% AGI threshold was adopted in 2010 (up from 7.5%). The provision simply brings the threshold amount back down to pre-2010 levels for 2017 and 2018.

Repeal of deduction for alimony payments and corresponding inclusion in gross income

Current law

Current law generally provides that alimony payments must be included in the income of the payee and may be claimed as an above-the-line deduction by the payor.

Provision

Under the provision, alimony payments would not be included in the payee's income and would not be deductible by the payor.

Effective date

The provision would be effective for divorce decrees and separation agreements executed after 2018, as well as for any modification made after 2018 to a divorce decree or separation agreement if it expressly states that this change is intended.

Implications

This provision first appeared in the House bill, but was not contained in the Senate bill. The Conference Agreement is similar to the House bill, except the effective date is delayed for one year. Unlike many of the other individual tax provisions in the bill, this one is permanent.

Suspension of the deduction for moving expenses and exclusion for qualified moving expense reimbursement

Current law

Current law generally allows a taxpayer to claim a deduction for certain moving expenses incurred in connection with beginning a new job in a new location. An employee may generally exclude from gross income any reimbursements of qualified moving expenses.

Provision

The provision generally would suspend for tax years 2018-2025 the deduction for moving expenses and the exclusion from gross income for reimbursement of qualified moving expenses, although the deduction and exclusion would be available to active duty members of the US Armed Forces (or their spouses or dependents) who incur moving expenses pursuant to a military order or permanent change of station (PCS).

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

This provision will make it more costly for employers to relocate their employees who will likely require tax gross-ups for taxable moving expenses.

Repeal of special rule permitting recharacterization of IRA contributions

Current law

Under current law, an individual may recharacterize a contribution to a traditional IRA as a contribution to a Roth IRA, or vice versa, if the election is made in a timely manner.

Provision

The provision would repeal this the ability to make such recharacterizations.

Under the provision, the special rule allowing recharacterization of IRA contributions would not apply to a conversion contribution to a Roth IRA. As a result, recharacterization could not be used to unwind a Roth IRA conversion, but would still be permitted with respect to other contributions.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

In general, a taxpayer would generally choose to recharacterize a conversion from traditional IRA to Roth IRA if the assets in the Roth IRA (on which the taxpayer paid tax in the year of conversion) decline over the next year. The new provision eliminates the benefit of the taxpayer's use of hindsight.

Modifications to estate, gift, and generation-skipping transfer taxes

Current law

Current law generally applies a top tax rate of 40% to property inherited through an estate. If a donor makes a gift of property during life, a top gift tax rate of 40% applies to any gift that exceeds the annual per-donee gift tax exclusion ($15,000 for 2018). If the donor gives property directly to grandchildren, for example, a generation-skipping tax applies, also at the 40% rate. The first $5 million in transferred property (the basic exclusion) is exempt from any combination of estate, gift, and generation-skipping taxes. Transfers between spouses are generally exempt from these taxes, and a surviving spouse may carryover (add) to his own basic exclusion any portion of his spouse's basic exclusion that has not been exhausted. A beneficiary who receives property from an estate receives a stepped-up basis in the property, but a donee who receives a gift from a living donor takes a carryover basis in the property.

Provision

The provision would double the estate and gift tax exemption for estates of decedents dying and gifts made between January 1, 2018 and December 31, 2025, by increasing the Section 2010(c)(3) basic exclusion amount from $5 million to $10 million, indexed for inflation occurring after 2011. The provision would also provide that Treasury prescribe regulations as necessary to address differences between the basic exclusion amount in effect at the time of the decedent's death and at the time of any gifts made by the decedent.

Effective date

The provision would be effective for estates of decedents dying and gifts made after December 31, 2017.

Implications

Although Republicans have tried since 2001 to repeal the estate tax, the tax has survived. The doubling of the basic exclusion means many more taxpayer's estates will not be subject to this tax. Thus, for 2018, an estate would have to have a net value of more than $11.2 million (the exclusion amount would have been $5.6 million in 2018) in order to be subject to this tax. That is a far cry from 2001, the first time the Republicans tried to repeal the estate tax, and the exclusion amount was $675,000. Because the provision continues to allow this amount to be portable, a couple would need to have a net estate of $22.4 million before they would be subject to this tax.

The provision leaves intact the current law that allows those beneficiaries who inherit from a decedent's estate a step-up in basis to the amount of the fair market value of the inherited property at the decedent's date of death.

Changes to electing small business trusts

Current law

An electing small business trust (ESBT) may be a shareholder of an S corporation. Generally, the eligible beneficiaries of an ESBT include individuals, estates, and certain charitable organizations eligible to hold S corporation stock directly. A nonresident alien individual may not be a shareholder of an S corporation and may not be a potential current beneficiary of an ESBT.

The treatment of a charitable contribution passed through by an S corporation depends on the shareholder. Because an ESBT is a trust, the deduction for charitable contributions applicable to trusts under Section 642(c), rather than the deduction applicable to individuals, applies to the trust. Generally, a trust is allowed a charitable contribution deduction for amounts of gross income, without limitation, which pursuant to the terms of the governing instrument are paid for a charitable purpose. No carryover of excess contributions is allowed.

Provision

The provision would allow a nonresident alien individual to be a potential current beneficiary of an ESBT. The Conference Agreement provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.

Effective date

The nonresident alien beneficiary provision would take effect on January 1, 2018. The change to the charitable deduction would apply to tax years beginning after December 31, 2017.

Implications

The addition of nonresident aliens as beneficiaries of ESBTs is a valuable addition to S corporations. As companies and families become increasingly global, the addition of nonresident aliens will require estate plans to adapt to family dynamics that may involve nonresident in-laws and heirs.

The change on the charitable contribution side is a puzzling one. It is puzzling because it is only applicable to the S portion of a trust, while the non-S portion of the ESBT will continue to use Section 642(c) as its deduction mechanism. If the change is in response to business realities, it should also have been applied to partnerships that are owned by nongrantor trusts. The provision simply creates a peculiar outlier in the world of trusts that will be the exception to the rule until the rest of Subchapter J catches up to it.

Elimination of shared responsibility payment for individuals failing to maintain minimum essential coverage

Current law

Under current law, Section 5000A imposes an excise tax on individuals (referred to as the "individual responsibility payment" or "individual mandate") who do not maintain health insurance for themselves and their family members, unless a specific exception applies. Premium tax credits under Section 36B are available to individuals below certain income thresholds who do not have access to employer-provided or government coverage and who purchase their coverage through a state or federal exchange (also referred to as "marketplace" coverage).

Provision

The provision would reduce the amount of the individual responsibility payment to zero.

Effective date

The provision would be effective with respect to health coverage status for months beginning after December 31, 2018.

Implications

The provision reduces the penalty for not having health insurance to zero, but counterintuitively raises revenue for the government. It is estimated to raise revenue because it is expected that individuals will no longer buy insurance and, therefore, will not need their insurance premium subsidies from the government.

While the revenue from the individual mandate was needed to balance the overall bill, the reduction of the individual responsibility payment to zero is a significant step in undoing the Affordable Care Act. It does not, however, actually undo any other provision of the Affordance Care Act and its cousin, the Health Care and Education Reconciliation Act. Therefore, unpopular taxes, such as the 3.8% net investment income tax and the 0.9% additional Medicare tax, remain intact.

Closely held business provisions

Deduction for qualified business income

Current law

The tax liability of individual taxpayers is determined by applying the tax rate tables to the taxpayer's regular taxable income, according to the taxpayer's filing status. Partnerships, S corporations, and sole proprietorships are generally treated as pass-through entities so income is taxed to the partners or owners on an individual basis, rather than at the entity level. The individual taxpayer may deduct his share of the entity's losses to the extent of the individual's adjusted basis in the pass-through entity (unless otherwise limited by the at-risk or passive loss rules); generally, unused losses may be carried over to the next year.

Provision

The provision generally would permit an individual taxpayer, for tax years beginning after December 31, 2017, and before January 1, 2026, to deduct: (1) 20% of qualified business income from a partnership, S corporation or sole proprietorship; and (2) 20% of aggregate qualified real estate investment trust (REIT) dividends, qualified cooperative dividends and qualified publicly traded partnership income. The deduction would not be permitted with respect to certain specified service trades or businesses above certain income levels (for married filing jointly taxpayers, the benefit of the deduction would be completely phased out if the taxpayer's taxable income exceeds $415,000). The 20% deduction may not be used in computing AGI and may be utilized both by non-itemizers and itemizers.

For a taxpayer with qualified business income, the deduction would be limited to the greater of: (1) 50% of W-2 wages paid with respect to a qualified trade or business or (2) the sum of 25% of W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis of all qualified property immediately after acquisition of such property. The wage/property limitation does not apply to individuals with income below $157,500 for individual filers and $315,000 for married filing jointly filers, and is phased in fully over the next $50,000 of income for individual filers and $100,000 of income for married filing jointly filers, indexed.

"Qualified property" would mean tangible, depreciable property that is: (1) held by or available for use in the qualified trade or business at the close of the tax year and (2) used in the production of qualified business income, and for which the depreciable period has not ended before the end of the tax year. (The depreciable period is the period beginning on the date the taxpayer first places the property in service and ending on the later of: (1) 10 years after the acquisition date or (2) on the last day of the last full year in the property's applicable recovery period under Section 168 (without considering Section 168(g)).

"Qualified business income" would be the net amount of domestic qualified items of income, gain, deduction and loss from the taxpayer's qualified business. A taxpayer's "qualified business" would mean any trade or business that generates items that would be effectively connected with the conduct of a trade or business within the United States, other than: (1) the trade or business of performing services as an employee; or (2) a specified service trade or business. A specified service trade or business is one that (1) has as its principal asset the reputation or skill of an owner or employee, or (2) involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading, or dealing in securities, partnership interests or commodities. For these purposes, "security" and "commodity" are defined as under Sections 475(c)(2) and 475(e)(2). The carve-out for income from specified service trades or businesses does not apply to individuals with income below $157,000 for individual filers and $315,000 for married filing jointly filers, and is phased in fully over the $50,000 of income for individual filers and $100,000 of income for married filing jointly filers, indexed.

Qualified business income would not include:

— Any amount paid to the taxpayer by an S corporation (or other pass-through entity that is engaged in a qualified trade or business of the taxpayer) that is treated as reasonable compensation of the taxpayer for services rendered to the trade or business;

— Any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership to the extent that the payment is in the nature of remuneration for those services (a Section 707(c) payment);

— To the extent provided in regulations, any amount a partnership pays to a partner who is acting other than in his capacity as a partner for services (a Section 707(a) payment);or

— Certain investment-related items of income, gain, deduction, or loss.

This is intended to deter high-income taxpayers from seeking to convert wages or other compensation for personal services to income eligible for the 20% deduction under this provision.

Trusts and estates would be eligible for the 20% deduction. Rules similar to those under Section 199 would apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualifying property under the limitation based on W-2 wages and capital.

Effective date

The provision would be effective for tax years beginning after December 31, 2017 and before January 1, 2026.

Implications

Of all of the non-corporate provisions (international excluded), this one is the most complicated. It will likely take months for taxpayers and the IRS to unpack these provisions, and time is of the essence. These provisions are functionally effective immediately and the IRS will have its work cut out for it in designing/redesigning forms and issuing temporary guidance on these provisions.

In a welcome amendment to the Senate's original bill, the provision now applies to estates and trusts. The only guidance on the application is a cross reference to now-repealed Section 199. It is likely that regulations similar to Treas. Reg. Section 1.199-5(e) will be republished under Section 199A to carry out the intent of Congress. But unlike Section 199, there are W-2 limits based on taxable income that are unique to Section 199A. It will not be easy for the IRS to apply these new concepts to charitable remainder trusts, ESBTs, and tax-exempt trusts that may claim the deduction to reduce unrelated business taxable income (UBTI).

The addition of REIT dividends and cooperative dividends will likely cause the Forms 1099 to change. Technical corrections might be needed to provide for character retention of the qualified REIT dividend when passing through mutual funds (RICs) and Common Trust Funds. There will also likely be changes to the Schedule K-1s for partnerships, S corporations and trusts to take into account these new dividend provisions.

The provision also amends the rules under Section 6662 for the definition of substantial understatement of tax penalty when the Section 199A deduction is claimed. Generally, Section 6662 imposes a penalty equal to 20% of any underpayment of tax attributable to a substantial understatement of income tax for any tax year if the amount of the understatement exceeds the lesser of: (1) 10% of the tax required to be shown on the return for the tax year or, if greater, $10,000, or (2) $10 million. If a Section 199A deduction is claimed, the threshold for the penalty is reduced to 5% of the tax required to be shown on the return for the [tax] year. The provision aims to prevent abuse, but the breadth of application is much broader than it needs to be. An individual with $10 million in taxable income and a $1,000 qualified REIT dividend that is entitled to a $200 deduction will have to choose whether to take the $200 deduction or risk the lower substantial understatement penalty threshold.

As with the Senate Bill and the House Bill, the Conference Agreement would cause certain pass-through owners to consider conversion to C corporation form. An individual's top effective marginal tax rate would be 29.6% for pass-through income under the Conference Agreement, assuming a top marginal rate of 37% and eligibility to use the full 20% Section 199A deduction. For an individual, the effective income tax rate on C corporation earnings would be approximately 36.8%, after considering double-taxation on corporate earnings and assuming distributions are treated as qualified dividends but excluding the 3.8% net investment income tax on dividends. With the 3.8% net investment income tax on dividends, the aggregate effective tax rate would be 39.8%. For example, on $100 of income, the C corporation would pay $21 of income tax, and if it distributed the remaining $79 to an individual as a dividend, the individual would pay $15.80 of income tax (20% of $79) and $3.00 of net investment income tax (3.8% of $79), leaving the individual with after-tax proceeds of $60.20 for an effective tax rate of 39.8%. This means that the effective tax rate resulting from double-taxation on C corporation earnings is only approximately 7.2% (or 10.2% also taking into account the net investment income tax) higher than that on pass-through earnings (if all such earnings are domestic QBI and eligible for the full 20% deduction). In certain cases, C corporation owners have the ability to defer the second level of tax by monitoring the timing of distributions. Moreover, the effective income tax rate for pass-through owners will be as low as 29.6% only if the entirety of such earnings is eligible for the 20% deduction. The exclusion of many types of service business income from the list of eligible income would limit the benefit of the 20% deduction for many individuals. The W-2 wage and qualified property limitation will also reduce the benefit of the 20% deduction for eligible pass-through income, closing the gap in effective tax rates between C corporations and pass-throughs.

Modification to interest expense

Current law

Current law allows business interest as a deduction in the tax year in which the interest is paid or accrued, subject to limitation rules, as applicable. Section 163(j) limits a corporation's ability to deduct disqualified interest (i.e., interest paid or accrued to a related party when no federal income tax is imposed on the interest) paid or accrued in a tax year if: (1) the payor's debt-to-equity ratio exceeds 1.5 to 1.0 (safe harbor ratio); and (2) the payor's net interest expense exceeds 50% of its adjusted taxable income. In general, adjusted taxable income is the corporation's taxable income calculated without taking into account deductions for net interest expense, NOLs, domestic production activities under Section 199, depreciation, amortization and depletion. Disallowed interest amounts may be carried forward indefinitely and any excess limitation may be carried forward for three years.

Provision

The provision would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjusted taxable income for purposes of this provision is modified from the Senate bill and would be a business's taxable income calculated without taking into account: (i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) NOLs; (iv) the amount of any deduction allowed under Section 199A; (v) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion; and (vi) such other adjustments as provided by the Secretary. Adjusted taxable income also would not include the Section 199 deduction, as it would be repealed.

The provision would exempt taxpayers with average annual gross receipts of $25 million or less for the three-tax-year period ending with the prior tax year. The limitation would not apply, at the taxpayer's election, to any farming business or to a real property trade or business as defined in Section 469(c)(7)(C). The limitation also would not apply to certain regulated public utilities.

For purposes of defining floor plan financing, the provision would modify the definition of motor vehicle by deleting specific references to an automobile, a truck, a recreational vehicle and a motorcycle because those terms are encompassed in "any self-propelled vehicle designed for transporting persons or property on a public street, highway, or road."

The provision would allow businesses to carry forward interest amounts disallowed under the provision to succeeding tax years indefinitely. Any carryforward of disallowed interest is an item taken into account in the case of certain corporate acquisitions described in Section 381 and is treated as a "pre-change loss" subject to limitation under Section 382.

The provision would include special rules to allow a pass-through entity's owners to use unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level.

It should be noted that, in the context of disallowed business interest, Section 381 also would be modified to provide that the acquiring corporation shall take into account, as of the close of the day of distribution or transfer, the carryover of disallowed business interest under Section 163(j)(2) to tax years ending after the date of distribution or transfer.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The provision generally adheres closely to the Senate bill, but modifies the definition of adjusted gross income to be computed without regard to deductions allowable for depreciation, amortization and depletion, as well as any modifications made by the Secretary.

As currently drafted, the provision does not include a grandfather rule for existing debt obligations.

The provision would reduce the advantage of financing merger and acquisition transactions with debt. To the extent the acquirer cannot deduct interest on acquisition debt, the economic cost of a debt-financed acquisition would be greater than under current law.

Taxpayers facing deferral or disallowance of interest deductions generally would have incentives to increase their net interest income, either by converting interest into another type of deductible expense or by converting another type of income into effectively tax-free interest income.

The treatment of disallowed interest carryovers as pre-change losses significantly broadens the relevance of Section 382. Because any carryforward of disallowed interest is subject to limitation under Section 382, it appears likely that highly leveraged companies will be subject to Section 382 solely as a result of having disallowed interest.

Modification to depreciation and expensing

Current law

Current law allows taxpayers to claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property (as described later) is placed in service through 2019 (with an additional year to place the property in service for qualified property with a longer production period, as well as certain aircraft). Bonus depreciation generally equals 50% of the cost of the property placed in service in 2017 and phases down to 40% in 2018 and 30% in 2019.

Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS), certain off-the-shelf computer software, water utility property or qualified improvement property. Certain trees, vines, and fruit-bearing plants also are eligible for bonus depreciation when planted or grafted. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer (i.e., used property does not qualify).

Under current law, taxpayers have the option of making an annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Alternatively, taxpayers may elect under Section 168(k)(4) to accelerate alternative minimum tax (AMT) credits (as refundable credits) in lieu of claiming bonus depreciation with respect to qualified property. Such election comes with the added requirement to depreciate that qualified property using a straight-line recovery method.

Provision

The provision would extend the additional first year depreciation deduction through 2026 (2027 for longer production period property and certain aircraft). The provision would allow taxpayers to claim 100% bonus depreciation with respect to qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). The provision would phase down bonus depreciation to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027 (with an additional year to place in service available for long production period property and certain aircraft associated with each phase-down percentage). The provision also would apply to certain plants planted or grafted after September 27, 2017, and before January 1, 2027, with similar bonus percentages in place.

The provision would also expand the current law definition of qualified property by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for 100% bonus depreciation if it is the taxpayer's first use of such property (provided that such "used" property is not acquired from a related party or in a carryover basis transaction). The provision would further expand the current law definition of qualified property to include certain qualified film and television productions, as well as certain qualified theatrical productions.

While the provision would generally expand the definition of qualified property, it specifically states that qualified property would not include property used by a regulated public utility company. Additionally, the provision states that qualified property would not include any property used in a trade or business that has had floor plan financing indebtedness (as defined in paragraph (9) of Section 163(j)), if the floor plan financing interest related to such indebtedness was taken into account in computing the interest limitation under Section 163(j). Further, a real property trade or business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate qualified improvement property under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation). Lastly, a farming business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate its property with a recovery period of 10 years or more under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation).

The provision also would repeal the election to accelerate AMT credits in lieu of bonus depreciation under Section 168(k)(4).

Effective date

The provision would apply to property acquired and placed in service after September 27, 2017, as well as specified plants planted or grafted after that date. Property would not be treated as acquired after the date on which a written binding contract is entered into for its acquisition. For property acquired prior to September 27, 2017, (e.g., property for which a binding written contract was entered into prior to September 27, 2017, to purchase the property), such property would be subject to the bonus depreciation rules in place prior to the enactment of the provision (as described under the "Current law" section above). A transition rule would allow a taxpayer to elect to utilize 50% bonus depreciation, instead of 100%, for qualified property placed in service during the first tax year ending after September 27, 2017.

Implications

The reinstitution of 100% bonus depreciation or immediate expensing for property meeting the definition of "qualified property" under Section 168(k)(2) would provide taxpayers acquiring such property with an immediate cash-tax benefit. Further, as the legislative language provides for the ability to elect out of the provisions of Section 168(k) consistent with current law, taxpayers that are in a loss position and that would not otherwise benefit from immediate expensing would have the flexibility to elect not to apply the provisions of Section 168(k) and, instead, utilize the depreciation provisions as set forth in Section 168 generally. Such election, along with other Section 168 elections to "slow down" depreciation (e.g., annual election to use the alternative depreciation system), will become more relevant in tax years beginning on or after January 1, 2022, when depreciation deductions will reduce "adjusted taxable income" for purposes of the 30% interest deduction limitation under Section 163(j). Companies will want to carefully model out the impact that depreciation elections will have on interest deductibility.

Because the expensing provision applies to qualified property acquired in a taxable acquisition, such as Section 1060 transactions or deemed asset acquisitions (such as those under Section 338), capitalized costs incurred in these transactions are also affected. In general, capitalized costs are added to the adjusted basis of acquired property and, if added to the adjusted basis of qualified property, would be subject to the immediate expensing provisions. In Section 1060 transactions, specifically identifiable costs may be allocated to individual assets. To the extent there are specifically identifiable costs that are allocable to qualified property, they will also be subjected to immediate expensing.

Modification of net operating loss deduction

Current law

Under current law, Section 172 allows taxpayers to carry back an NOL arising in a tax year for two years and carry forward the NOL for 20 years to offset taxable income. Generally, an NOL is the excess of the taxpayer's business deductions over its gross income. Section 172 also provides special provisions modifying the carryback period for specific types of losses or losses arising in particular years. Included in these special provisions is Section 172(f), which allows a 10-year carry back of losses arising from specified liabilities. The AMT rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%.

Provision

The provision would make two significant changes to the rules governing NOL deductions. First, NOLs arising in tax years beginning after December 31, 2017, may be carried forward indefinitely but may not be carried back. Second, for losses arising in tax years beginning after December 31, 2017, the amount of an NOL that a taxpayer could use to offset taxable income would be limited to 80% of taxable income.

Effective date

The indefinite carryforward and modification of carrybacks would be effective for losses arising in tax years beginning after December 31, 2017. The 80% limitation rule would apply to losses arising in tax years beginning after December 31, 2017.

Implications

The change to the NOL carryback rule eliminates the ability for a taxpayer to carry back the NOL to a tax year with rates significantly higher than when it is generated. This is a valid concern for corporations that have the benefit of a significant rate cut, but will have much less impact on individuals. However, the NOL carryback rule has been a favorite statutory mechanism that Congress uses to infuse cash into the economy during economic downturns. So it will not be much of a surprise if the carryback reappears in the future.

The 80% NOL limitation is a significant change. It basically adopts the AMT concept to regular tax NOLs, but takes it a step further by limiting it to 80% of income (versus 90%). This rule now ensures that virtually all taxpayers will pay tax at some level.

Limitation on losses for taxpayers other than corporations

Current law

Passive loss rules limit the deductions and credits that individuals, estates, trusts and closely held corporations may claim attributable to passive trade or business activities, allowing passive losses to be deducted only against passive gains. A passive activity is a trade or business activity in which the taxpayer holds an interest but does not materially participate (i.e., the taxpayer's involvement in the activity is not regular, continuous or substantial). Deductions and credits from passive losses that may not be claimed in one year generally may be carried forward to the next tax year; suspended losses from a passive activity may be deducted in full when the taxpayer disposes of his entire interest in the activity to an unrelated party.

Excess farm losses are limited for taxpayers other than C corporations. If a taxpayer other than a C corporation receives an applicable subsidy for the tax year, the excess farm loss may not be claimed for that year and must be carried forward and treated as a deduction attributable to farming the next year. An excess farm loss for a tax year is the amount by which aggregate deductions attributable to farming exceeds the sum of aggregate gross income or gain attributable to farming, plus a threshold amount. The threshold amount is the larger of: (1) $300,000 (for married couples filing jointly; $150,000 for single taxpayers); or (2) for the five-year period preceding the tax year, the excess of the taxpayer's aggregate gross income or gain attributable to farming over the aggregate deductions attributable to farming.

Provision

The provision would disallow excess business losses, including the excess farm loss, for taxpayers other than C corporations. These losses may be carried forward and treated as part of the taxpayer's NOL carryforward. An excess business loss is: the excess of the taxpayer's aggregate deductions attributable to the taxpayer's trades or businesses over the sum of the taxpayer's aggregate gross income or gain, plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for other individuals). For partnerships or S corporations, the provision would apply at the partner or shareholder level.

Effective date

The provision would be effective for tax years beginning after December 31, 2017 and before January 1, 2026.

Implications

This provision, the origins of which were in the Senate bill, is going to be a difficult one for taxpayers and the IRS to deal with. The loss limitation provision disallows excess business losses, but leaves many open questions concerning what exactly constitutes a business loss. There is some question concerning the treatment of gains from the dispositions of interests in partnerships and S corporations, and whether those gains/losses would go into the calculation of net business loss. Intuitively, the rule should be interpreted to simply capture net nonpassive losses (within the meaning of Section 469) in excess of the $250/500k limit, but because the passive loss rules cover activities that are broader than Section 162 businesses, it might not be precise enough.

Individual taxpayers who would be most affected by this provision will be those in the oil & gas and real estate fields. The combination of this loss limitation and the 80% NOL rule will basically require them to pay tax each year even though they incur economic losses.

The provision would also apply to estates and trusts. In the case of an ESBT, the provisions would likely apply on the S-portion and the non-S portion independently. In theory, the provisions could also apply to a charitable remainder trust (CRT) (depending on how business loss is defined), but it is uncertain how the NOL provision would work when a CRT cannot have one.

The statutory language does not grant the IRS legislative regulation writing authority to assist with the implementation of this rule. Therefore, the IRS could feel somewhat constrained by only being able to use its interpretative regulations writing authority to clear up ambiguities (similar to what they were faced in implementing the net investment income tax in 2013).

Not included

Provisions that didn't make it into the Conference Agreement include:

— Modification of exclusion of gain on sale of a principal residence
— Clarification of whistleblower awards
— Sunset of exclusion for dependent care assistance programs
— Exclusion from gross income of certain amounts received by wrongly incarcerated individuals
— Attorneys' fees relating to awards to whistleblowers
— Modification of rules relating to hardship withdrawals from cash or deferred arrangements
— Reduction in minimum age for allowable in-service distributions
— Modification of rules governing hardship distributions
— Modifications of user fees requirements for installment agreements
— Repeal of credit for plug-in electric drive motor vehicles
— Repeal of exclusion for adoption assistance programs
— FIFO for cost basis related to disposition of securities

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Contact Information
For additional information concerning this Alert, please contact:
 
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Greg Rosica(813) 225-4925;
Jim Medeiros(617) 585-1828;
People Advisory Services — Mobility
Mohamed Jabir(214) 665-5781;
Renee Zalatoris(312) 879-2247;
 

 


 

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