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Excellence

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Tax Reform Now
  • Part 9

    November 17, 2017

    On November 16, 2017, the House of Representatives approved its version of the “Tax Cuts and Jobs Act” (the “Act”) by a vote of 227-205. All Democrats and 13 Republicans voted against the tax bill. Although potential obstacles still exist, Republicans are one step closer towards enacting comprehensive tax reform. The Senate Finance Committee is currently working on its tax reform bill. If the Senate passes this bill, a conference committee will be held to resolve the differences between the two versions. “Tax Reform Now” will highlight the significant changes included in the House’s tax bill for estates, individuals, pass-through businesses, and corporations.

    Estates

    The Act defangs the estate tax. Beginning in 2018, an unmarried individual’s estate, gift, and generation-skipping transfer tax exclusions will be doubled to almost $11 million. Thus, an unmarried individual can pass up to $11 million to his or her heirs without paying federal estate tax. A married couple can pass up to $22 million without paying federal estate tax. Furthermore, the House’s tax bill completely phases out the estate tax following the 2024 tax year.

    Individuals

    The Act seeks to streamline the individual income tax code and encourage more taxpayers to use the standard deduction. Under the Act, there will be four income tax brackets. These brackets will be 12%, 25%, 35%, and 39.6%. The alternative minimum tax will be repealed. The standard deduction will double to around $12,000 for unmarried individuals and $24,000 for married couples.

    The Act eliminates nearly all itemized deductions. The status of some itemized deductions are worth mentioning. The charitable contribution deduction will be expanded under the Act. An individual will be able to take a deduction of up to 60% of the individual’s adjusted gross income for cash contributions to public charities or certain public foundations. Other itemized deductions will be eliminated or scaled back. For example, the alimony payment deduction will be repealed. As a result, an ex-spouse will not have to include alimony payments in gross income. This law will apply to any divorce or separation instrument executed after December 31, 2017. In the House, the status of the state and local tax deduction has been a divisive issue. The House’s tax bill allows an individual to deduct up to $10,000 of state and local property taxes. However, the deduction for state and local income taxes or sales taxes will be repealed. Many individuals currently take the home mortgage interest deduction. This deduction will be scaled back under the Act. The current home mortgage interest deduction rules will apply to all mortgages incurred on or before November 2, 2017. However, the home mortgage interest deduction rules will change for all mortgages incurred after that date. A married couple who purchases a home after November 2, 2017 will be entitled to take a maximum $500,000 home mortgage interest deduction. A married couple currently can take a $1 million home mortgage interest deduction on a principal residence and one other residence. Under the new rules, the home mortgage interest deduction can only be taken for mortgage interest paid on the individual’s principal residence.

    The Act contains other interesting provisions. The Act changes the requirements that an individual must satisfy before he or she can exclude a portion of the gain from the sale of a principal residence from gross income. In order to exclude the gain, an individual must own and use the residence as a principal residence for five of the previous eight years. This exclusion can apply to one sale or exchange every five years. The Act restricts who can utilize this exclusion. A married couple with adjusted gross income greater than $500,000 will not be able to use this exclusion. Additionally, an individual will no longer be allowed to recharacterize a contribution to a traditional IRA as a contribution to a Roth IRA (or vice versa). Finally, the like-kind exchange rules will be altered. The gain or loss deferral on like-kind exchanges will only apply to like-kind exchanges of real property.

    Pass-through Businesses

    Under the Act, an individual owning a pass-through business will benefit if his or her pass-through business has net income above the 25% tax bracket threshold. When such a pass-through business distributes its net income to that individual, 30% of the distributed income will be treated as “business income” taxed at a maximum 25% rate. The remaining 70% of the distributed net income will be taxed at the individual’s personal income tax rate.

    The amount of “business income” depends on whether the income derives from an active or passive business activity. The current material participation and activity rules will determine whether a business is considered an active or passive business activity. This distinction is important. All net income derived from a passive business activity will be treated as “business income.” For example, a limited partner is engaged in a passive business activity. Since passive investors are entitled to this preferential rate, individuals may be more inclined to be treated as passive investors.

    The calculation of an individual’s “business income” derived from an active business activity is more complicated. First, an individual determines his or her net income derived from the active business activity. An individual’s wages would be included in net income. After calculating the net income, that individual determines the amount of “business income” eligible for the 25% rate. The amount of “business income” is 30% of the net income derived from the active business activity. The House refers to this 30% rate as a “capital percentage.” The resulting dollar amount is the amount of “business income” eligible for the preferential 25% rate. The remaining 70% of the net income passed through to the individual would be taxed at the individual’s income tax rate. An individual can choose to apply a different formula in order to get a “capital percentage” of greater than 30%. However, the facts and circumstances of the business will determine whether the individual can receive a larger rate. The election to use this formula will be binding for five years.

    An individual working in a personal service business will have a capital percentage of 0%. A personal service business includes any business engaged in services related to law, accounting, consulting, engineering, financial services, or performing arts. As a result, an individual actively participating in a personal service business generally will not be eligible for the 25% rate on “business income.” That individual will continue to be taxed at their own individual income tax rate.

    Corporations

    Corporations are the biggest beneficiaries under the Act. The corporate tax rate will be lowered from 35% to a flat 20% rate starting in 2018. This rate reduction is the biggest one-time drop in the maximum corporate tax rate in United States history. To encourage more investment in businesses, the Act will allow businesses to immediately deduct the entire cost of investment in “qualified property” acquired and placed in service after September 27, 2017. This immediate deduction will be available for five years. However, “qualified property” does not include any property used in a real property trade or business. Like the House’s treatment of most deductions, a corporation’s dividend received deduction will be scaled back. If a corporation owns more than 20% of the distributing corporation’s stock, the corporation can deduct 65% of the dividends received. If a corporation owns less than 20% of the distributing corporation’s stock, the corporation can deduct 50% of the dividends received.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 8

    November 3, 2017

    On November 2nd, the House Ways and Means Committee unveiled the first draft of the “Tax Cuts and Jobs Act.” The House Ways and Means Committee will revise the “Tax Cuts and Jobs Act” during its mark-up session beginning on November 6th. However, the initial draft of the “Tax Cuts and Jobs Act” includes impactful changes to the Internal Revenue Code. “Tax Reform Now” will briefly highlight some relevant changes.

    Corporate Income Tax Brackets
    Current Law – There are seven income tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.

    Proposed Law – There will be four income tax brackets: 12%, 25%, 35% and 39.6%.

    Estate and Gift Tax
    Current Law – A taxpayer can pass (during life or upon death) up to $5.49 million to his or her heirs without paying any federal estate tax (married couples can pass up to $10.98 million). If a taxpayer owns more than that, upon his or her death, the estate must pay a federal estate tax of 40%.

    Proposed Law – The estate, gift and generation – skipping transfer tax exclusions doubles to almost $11 million beginning in 2018. That is, a taxpayer can pass up to $11 million to his or her heirs without paying federal estate tax and married couples will be able to pass up to $22 million. Please note that the estate tax will be phased out beginning in the 2024 tax year. Additionally, beginning in 2024, the top gift tax rate would be lowered to 35%.

    Pass-through Businesses 
    Current Law – Sole proprietorships, partnerships, limited liability companies, and S corporations are generally treated as pass-through businesses subject to tax at the individual owner or shareholder level. Thus, an individual owning an interest in a pass-through business is taxed on any business profits at their own individual income tax rate. The maximum individual income tax rate is 39.6%.

    Proposed Law – For a pass-through business that distributes net income to an individual, a portion of the distributed net income will be treated as “business income.” The maximum tax rate on this portion of “business income” will be 25%. The remaining portion of net income distributed to an individual will be compensation subject to the individual income tax rates.

    Corporate Income Tax Brackets

    Current Law – The maximum corporate tax rate is 35%.

    Proposed Law – Starting in 2018, the corporate tax rate will be a flat 20% rate.  However, personal service corporations will be subject to a 25% corporate tax rate.

    State and Local Tax (“SALT”) Deduction
    Current Law – An individual must itemize their deductions in order to take the SALT deduction. The SALT deduction allows an individual to deduct state and local property taxes along with state and local income taxes or sales taxes from their federal income tax bill.

    Proposed Law – An individual can deduct state and local real property taxes up to $10,000. An individual will not be allowed to deduct state and local income taxes or sales taxes. By capping the amount of the SALT deduction, more individuals will switch from itemizing their deductions to utilizing the larger standard deduction.

    401(k) Plans and Individual Retirement Accounts
    The “Tax Cuts and Jobs Act” will not substantively alter the tax treatment of 401(k) plans and Individual Retirement Accounts.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 7

    October 30, 2017

    As explained in Part 2 of “Tax Reform Now”, Republican lawmakers sought an outright repeal of the state and local tax deduction (“SALT deduction”) in order to offset tax cuts.  After encountering criticism from both political parties and lobbyists, Republican lawmakers have renounced this position.  Although the new tax reform bill has not been released, Kevin Brady, the Chairman of the House Ways and Means Committee, announced that the SALT deduction will be included in the tax reform bill.  A taxpayer who itemizes their deductions can currently take the SALT deduction.  The SALT deduction allows a taxpayer to deduct state and local property taxes along with state and local income taxes or sales taxes.  It is unclear how the SALT deduction will change in the new tax reform bill.  The details of the new tax reform bill will be announced this week.  Following this announcement, “Tax Reform Now” will explain the new SALT deduction and its effect on taxpayers.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 6

    October 27, 2017

    On October 26th, the House of Representatives approved the budget resolution previously passed by the Senate. Because the House approved the Senate’s budget resolution without making any changes, a conference committee will not be necessary. Avoiding a conference committee speeds up the timeline for tax reform. The budget resolution passed 216-212 in the House. All Democrats and 20 Republicans voted against the budget resolution. As expected, most Republicans who voted against the budget resolution were those who do not want the state and local tax deduction (“SALT deduction”) to be eliminated or scaled back. Repealing the SALT deduction in its entirety could generate more than $1 trillion in revenue that would help offset the proposed tax cuts. Part 2 of “Tax Reform Now” describes why repealing the SALT deduction is a contentious issue. Since the budget resolution included the budget reconciliation instructions, a tax reform bill can now be approved by a majority vote in the Senate. Part 5 of “Tax Reform Now” explains in greater detail how the budget reconciliation instructions impact long-term tax reform.

    Republican leaders want to pass a tax reform bill through Congress before Thanksgiving. Thus, Republicans have approximately three weeks to achieve this goal. Because the Senate’s budget resolution was passed by the House, the House and Ways Means Committee is now tasked with drafting the tax reform bill. Kevin Brady, the House Ways and Means Committee Chairman, announced that a draft of the tax reform bill should be released on November 1st. After this draft is released, the House Ways and Means Committee will hold a mark-up session starting on November 6th. In a mark-up session, the House Ways and Means Committee members will debate, propose amendments, and rewrite the proposed tax reform bill. While this mark-up session is going on, the Senate Finance Committee will be gearing up for its own mark-up session.

    Since the release of President Trump’s framework for tax policy reform in late September, the details of any tax reform legislation have been shrouded in mystery. Republican leaders have not yet reached a consensus on thorny issues. Nevertheless, the House Ways and Means Committee’s draft of the tax reform bill will provide answers for individuals and businesses anticipating significant tax changes. When the draft of this tax reform bill is released, “Tax Reform Now” will provide a summary of the proposed changes.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 5

    October 25, 2017

    On October 19th, the Senate approved a $4 billion budget resolution, which now paves the way for passage of a tax bill using the budget reconciliation rules. This budget resolution passed 51-49 in the Senate, with Rand Paul being the lone Republican Senator to vote against it. As mentioned in Part 3 of “Tax Reform Now,” the House of Representatives previously passed a budget resolution with budget reconciliation instructions. The House’s budget resolution stated that any tax cuts must be offset by tax increases or spending cuts. The Senate’s budget resolution did not follow the House’s philosophy. Instead, the Senate’s budget resolution would add $1.5 trillion to the federal deficit over the next ten years.

    The most important aspect of the Senate’s budget resolution is its inclusion of budget reconciliation instructions. These instructions allow a future tax bill to pass by a simple majority vote in the Senate. Typically, the political party in the Senate minority can filibuster a bill unless there are 60 votes to break the filibuster. By including the budget reconciliation instructions in the budget resolution, a future tax bill cannot be filibustered by Democrats if the tax bill adds $1.5 trillion or less to the federal deficit. There is a drawback to enacting tax reform using budget reconciliation. If a tax bill is passed using budget reconciliation, the Senate rules do not allow the tax bill to increase the federal deficit beyond the first ten years after its enactment. Like the Bush administration’s tax cuts enacted using budget reconciliation in the early 2000s, any tax cuts would be temporary and “sunset” after ten years.

    Before the budget reconciliation instructions take effect, the House and Senate must pass identical budgets. Interestingly, the Senate’s budget resolution includes an amendment that allows the House to adopt the Senate’s version of the budget. Either the House will pass the Senate’s budget resolution without making any changes, or the budget resolution will go to a conference committee between the two chambers. It is common for a budget resolution to go to a conference committee. A conference committee usually takes a week or two to resolve any differences. However, the Senate’s budget resolution is expected to pass the House without the need for a conference committee because the Senate’s budget resolution included amendments that appeased House Republicans. Avoiding a conference committee speeds up the timeline for tax reform. If the Senate’s budget is passed by the House, the House Ways and Means Committee will draft the tax reform legislation. Republican leaders hope that the tax bill will be ready to be presented to the House by early November.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 4

    October 18, 2017

    A Compromise on the State and Local Tax Deduction?

    There has not been much progress in the last week with respect to President Trump’s plan for tax reform, except with respect to the state and local tax deduction (“SALT deduction”). The debate over the future availability of the SALT deduction has been an initial obstacle for Republican lawmakers attempting to reach an agreement on tax reform. Part 2 of “Tax Reform Now” discussed why potentially repealing the SALT deduction is a contentious issue. Instead of an outright repeal of the SALT deduction, Republican lawmakers are now exploring other options. One option gaining traction is making the SALT deduction available to taxpayers earning less than a specified amount of income. Taxpayers earning more than this income threshold would no longer be able to take the SALT deduction. Although an exact amount has not been specified, recent discussions have an amount somewhere between $200,000 and $400,000 as the income threshold. However, the final decision regarding the SALT deduction will not be known until the House of Representatives introduces its tax bill.

    2704 Proposed Regulation

    Although not related to the current tax reform initiative in Washington, we wanted to let you know that on October 3, 2017, the Treasury Department withdrew Proposed Treasury Regulations to Section 2704 of the Internal Revenue Code issued last year. Had they been finalized, the Proposed Regulation would have reduced or eliminated the ability to use minority-interest and marketability discounts for transfers of interests in family controlled entities. The Treasury Department withdrew the Proposed Regulation citing, “the Proposed Regulation’s approach to the problem of artificial valuation discounts is unworkable.”

     

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 3

    October 11, 2017

    On October 5, the House of Representatives took the first step in overhauling the United States tax code when it passed a budget resolution. This budget resolution would allow a future tax bill to pass in the House and the Senate without the support of any Democrats. In a 219 to 206 vote, 18 Republicans and all Democrats voted against the House’s budget resolution. As discussed in last week’s edition of “Tax Reform Now”, some Republican Representatives voted against the budget resolution because of the potential repeal of the state and local tax deduction. The House’s budget resolution now serves as a blueprint for federal spending during the 2018 fiscal year. This week’s edition of “Tax Reform Now” will discuss the reconciliation language in the House’s budget resolution along with the next steps that legislators will take.

    The House’s budget resolution includes language for a procedure called reconciliation, which will allow a future tax bill to avoid a filibuster in the Senate. Instead of needing 60 votes to overcome a filibuster, Republicans can pass a tax bill in the Senate with 51 votes. If there is a tie, Vice President Pence would then cast the deciding vote. This parliamentary language was added because the Republicans only hold 52 seats in the Senate. However, in order to use reconciliation and avoid a filibuster, the House and Senate must first agree on an identical budget resolution for the 2018 fiscal year. If the House and Senate can decide on an identical budget resolution, a tax bill that satisfies the approved budget conditions will avoid a filibuster.

    The House’s budget resolution discusses how to eliminate annual budget deficits by the end of the decade. The House assumes its proposed budget resolution will not add to the federal deficit by providing $203 billion in spending cuts. The Senate Budget Committee has advanced its own budget resolution, which would allow legislators to add up to $1.5 trillion to the budget deficit. The Senate Budget Committee’s resolution must be approved by the Senate. The Senate will vote on this budget resolution next week. If the Senate passes this budget resolution, the House would need to pass the Senate’s version of the budget without making any changes, or else the budget must go to a conference committee to resolve any differences. The House and Senate would vote again on the budget resolution offered by the conference committee. If the budget resolution is approved by the House and Senate, the House Ways and Means Committee would then meet to draft a tax bill.

    We hope this update has been helpful. As always, please let us know if you have any questions.

     

  • Part 2

    October, 4, 2017 
    “Repeal of the State and Local Tax Deduction?”

    As mentioned in last week’s edition of “Tax Reform Now,” President Trump’s “Unified Framework for Fixing Our Broken Tax Code” would eliminate most itemized deductions. Although the home mortgage interest and charitable contribution deductions would be retained, this framework would eliminate the widely used state and local tax deduction (“SALT deduction”). The Trump administration believes the revenue generated from eliminating the SALT deduction would help defray the costs of other proposed tax cuts in the framework. Proponents of eliminating the SALT deduction argue that taxpayers living in states that impose less state and local taxes currently subsidize taxpayers living in states that impose more state and local taxes. Merely talking about eliminating the SALT deduction has triggered backlash from both political parties. As a result, the SALT deduction may be used as a potential bargaining chip in ongoing discussions between Republicans and Democrats.

    The SALT deduction can be taken by a taxpayer who itemizes their deductions. The SALT deduction allows a taxpayer to deduct property taxes along with state and local income taxes or sales taxes. Due to the availability of this deduction, some states and local governments have imposed more onerous taxes on taxpayers. Wealthy taxpayers living in states that impose more state and local taxes, such as California and New York, can utilize the SALT deduction to reduce their federal income tax bill by the amount paid to their state and local governments. This deduction is typically one of the largest itemized deductions taken by taxpayers. By eliminating the SALT deduction, wealthy taxpayers living in states that impose more state and local taxes would pay more taxes. Less affluent taxpayers living in these states are likely to switch from itemizing their deductions to utilizing the larger standard deduction offered in Trump’s framework. If the SALT deduction is repealed, states and local governments may feel pressure from their constituents to lower state and local taxes.

    The states that would be most affected by the elimination of the SALT deduction are traditionally “blue” states. However, Republican politicians from California, New York, New Jersey, and Illinois have spoken out against eliminating the SALT deduction. These politicians do not want their constituents to pay more taxes. They are also apprehensive about not being reelected, which could result in the Republicans losing control over the House of Representatives in 2018. Their resistance has produced immediate results. During this past week, the Trump administration mentioned that eliminating the SALT deduction is a position up for negotiation.

    The fate of the SALT deduction may decide whether President Trump has enough clout to enact his proposed tax framework. If the SALT deduction is not completely eliminated, the Trump administration must find other revenue streams to defray their proposed tax cuts. “Tax Reform Now” will provide updates about this contentious deduction when more information is disseminated.

    And what happens to basis?

    Under the current tax regime, taxpayers receive a step-up in basis when they inherit property. For example, imagine that you inherit a painting today that your mother purchased for $2 million. Now, that painting is worth $20 million. Upon your mother’s death, you receive a step-up in basis to the current fair market value: $20 million. That is, you receive the painting with a basis of $20 million. You avoid recognizing any gain that accrued during the time your mother owned it ($18 million) when you ultimately sell the property. This has been the law for some time.

    However, in his campaign, President Trump proposed eliminating the basis step-up for assets exceeding $10 million. At this point, it is not clear whether the proposed framework supports (with respect to the above scenario) (1) an income tax recognition event at death, whereby your mother’s estate would recognize $18 million of gain at her death; or (2) a carry-over of the basis, whereby you would receive the painting with a basis of $2 million (the basis in which your mother had) and when you chose to sell the painting, would recognize whatever the gain is at that time (at its sale price). Clause (1) proposes a deemed recognition event at death for assets exceeding $10 million – this has never been seen before in our tax law. A forced recognition event, as described in clause (1) above would be problematic if the decedent did not have sufficient liquid assets to pay the tax. If that is the case, it will be crucial for individuals who have assets in their estate that have appreciated greatly, along with individuals who have few liquid assets, to plan in advance for more liquidity. A typical planning tool would be to purchase a life insurance policy in an amount sufficient to pay such taxes, whether income or estate (or to continue holding an existing life insurance policy).

    Where do we go from here?

    A bill regarding tax reform is expected to be introduced in early November. Before the bill can be written, a 2018 budget resolution must be adopted in order for the tax-writing committees to know the financial parameters of the bill. If the House and Senate fail to adopt a budget resolution that is filibuster proof, there will likely be no significant tax reform this year. Additionally, Republican House members have already shown dissidence with the elimination of the state and local tax deduction. A split Republican Party will make it more difficult for any tax legislation to be passed.

    We hope this update has been helpful. As always, please let us know if you have any questions.

  • Part 1

    September 27, 2017

    “Unified Framework for Fixing Our Broken Tax Code”
    On Wednesday September 29, 2017, President Trump unveiled a framework for his tax policy reform, entitled the “Unified Framework for Fixing Our Broken Tax Code”. If the tax overhaul takes place as planned, this will be the country’s largest tax reform since 1986. A summary of the proposed major changes follows:

    Income Tax Brackets. The framework collapses the seven current individual income tax brackets into three brackets at 12%, 25% and 35%.

    Deductions. The framework proposes doubling the standard deduction to $24,000 for married taxpayers filing jointly and $12,000 for single filers.   President Trump’s plan additionally eliminates most itemized tax deductions, except for the deduction for mortgage interest payments and charitable deductions.

    Estate/Generating Skipping Tax. The framework proposes repealing the estate tax and generation-skipping tax, but does not give any further details of how that will be accomplished.

    Alternative Minimum Tax. The framework also proposes repealing the individual alternative minimum tax.

    New Tax Structure for Small Businesses. The framework creates a new tax rate structure for small businesses. For small businesses organized as sole proprietorships, partnerships, or S corporations, the maximum tax rate on any business income will be 25%. Individuals owning interests in these pass-through businesses are currently taxed on any business profits at their own individual income tax rates.

    Corporations. The framework proposes to lower the top federal tax rate for corporations from 35% to 20%. The corporate alternative minimum tax will also be eliminated. Although no details were provided, the framework suggests that future efforts may be made to reduce the double taxation of corporate earnings.

    Elimination of Certain Business Deductions and Credits. The framework expresses the goal of limiting the number of business deductions and credits. The domestic production deduction will be eliminated. The net interest expense deduction taken by C corporations will be partially limited. Although the framework discusses the goal of limiting business credits, the business credits for research and development and low-income housing will be retained.

    Immediate Deduction for Purchased Depreciable Assets. Under the framework, companies will be able to immediately write off the entire cost of investments in depreciable assets purchased after September 27, 2017. Companies will be able to take advantage of this immediate deduction for at least the next five years. Companies can currently deduct the cost of depreciable assets over a period of years.

    Repatriation of Foreign Profits. To avoid paying the corporate tax on profits earned outside of the United States, United States-owned multinational companies have opted to keep these foreign earnings in overseas tax havens. This framework encourages these multinational companies to return foreign earnings and illiquid assets to the United States. The framework proposes that the United States switch to a territorial tax system, meaning that multinational companies would no longer pay taxes in the United States on any foreign earnings. These multinational companies will only pay taxes to the government of the country where the money was earned. However, multinational companies would be required to pay a one-time repatriation tax on their existing foreign earnings. All foreign earnings will then be treated as repatriated (or returned) to the United States. Foreign earnings will be taxed at different tax rates depending on if the foreign earnings are in cash or illiquid assets. If a company has earnings invested in illiquid assets, the repatriated illiquid assets will be taxed at a lower rate than cash or cash equivalents. Companies will be able to pay this proposed repatriation tax over an unspecified number of years. The framework does not specify the proposed repatriation tax rate.