Yesterday, House Ways and Means Committee Chairman Dave Camp (R-MI) released his much anticipated comprehensive discussion draft to overhaul the corporate and individual income tax provisions of the Internal Revenue Code. “We’ve already lost a decade, and before we lose a generation, Washington needs to wake up to this reality and start offering concrete solutions and debating real policies that strengthen the economy and help hardworking taxpayers,” Camp urged in a statement accompanying the release. “Tax reform is one way we can do that.”
The proposal marks a critical milestone in the path toward comprehensive tax reform, culminating from a multitude of committee hearings, the tax reform “road show” of Chairmen Camp and Baucus, the formation of various tax working groups, as well as the release of wide ranging tax reform options papers and specific working drafts. Many observers have noted that Chairman Camp and a cadre of dedicated staff have been working on their vision of a reformed Code virtually nonstop for three years, and the sheer scope of this draft demonstrates that to be true. The draft proposes to fundamentally overhaul the tax Code for both corporations and individuals by reducing tax rates and paying for those reductions by curtailing or eliminating scores of tax preferences that have been on the books for decades, some of which are woven into the fabric of society.
For individuals, the draft reduces the number of tax brackets from seven to three: 10, 25, and 35 percent. It restricts most preferences for upper-income earners to a 25 percent benefit level; the means by which this is accomplished is a fairly complicated surtax levied on modified adjusted gross income which sweeps in items excluded from income under current law, such as municipal bond interest, 401(k) contributions, and the exclusion for employer-provided healthcare. In addition, the draft eliminates completely the deduction for State and local taxes and significantly curtails the deduction for mortgage interest. Taxes on capital gains and dividends are changed but effectively remain at or near current law levels. The top corporate tax rate of 35 percent is reduced to 25 percent over a five-year phase-in period and is paid for by a host of changes to long-standing business tax rules, including the deduction of advertising expenses, the calculation of capital cost recovery allowances, and the taxation of financial companies and instruments.
Unsurprisingly, the Chairman’s draft also proposes to transition the Code towards a territorial tax system, whereby only a small fraction of income of overseas subsidiaries is taxed by the U.S., and includes a series of safeguards to prevent erosion of the tax base, including a “thin capitalization” rule and significant changes to the subpart F regime.
Along with the draft, Chairman Camp provided both static and dynamic scores of the proposal from the Joint Committee on Taxation (JCT). When scored on a static basis, the draft, which literally moves trillions of dollars around, nets out as essentially revenue neutral, raising just $3 billion over a 10-year period. While at first glance the draft appears to lower the tax on individuals by nearly $600 billion, while raising taxes on corporations by a like amount, it is likely that this greatly overstates things as the business title of the bill includes provisions that increase taxes on individuals who own businesses directly or through pass-through entities, making it difficult to assess exactly how much, if any, corporate revenue is being used to subsidize the individual provisions.
In addition, JCT took the rare step of providing a full macroeconomic (dynamic) analysis of the Camp proposal. Using that model, JCT found that the Camp proposal, if enacted, could increase employment by 1.8 million jobs and economic activity by $3.4 trillion over the 10-year scoring window, thereby raising $700 billion in new revenue to the government. While the battle as to the best method of scoring tax legislation will no doubt continue to rage, we are reminded that on matters such as these, where you stand often depends on where on the dais you sit.
Whether Chairman Camp will push for a Committee mark-up of the proposal remains an open question, with floor action on a measure even more uncertain. Notably, despite House Leadership’s symbolic reservation of H.R. 1 for fundamental tax reform legislation, Camp’s proposal was not formally introduced, but rather released as a discussion draft. With midterm elections approaching, Congressional leaders will be reluctant to force their members to take difficult votes on tax reform legislation, and comments from the House Speaker John Boehner (R-OH) all the way down to rank and file Members have suggested a reluctance to take an official position on the measure.
On the Senate side, Senate Minority Leader Mitch McConnell (R-KY) has suggested that, given continued partisan divide over whether reform should raise revenue, he has “no hope” for comprehensive reform happening this year. Following release of the proposal, Senate Finance Committee Chairman Ron Wyden (D-OR) and Ranking Member Orrin Hatch (R-UT) issued a joint statement commending Camp for his efforts, but emphasizing the need for bipartisan reform. Compounding matters, a newly installed Chairman Wyden has indicated that he intends to focus first on legislation resuscitating expired tax extenders, rather than fundamental reform.
While the prospects of enacting tax reform this year remain low, yesterday’s release will instigate serious discussion and jockeying by any sector of the economy affected by the proposal. It is also possible that provisions in the bill, particularly those with a proposed effective date of February 26, 2014 and those that affect the tax consequences of transactions and arrangements entered into before the provisions are effective, could place a chill on proposed financing and other transactions.
The following highlights select provisions of the discussion draft and is not meant to be an exhaustive treatment of the proposal.
Chairman Camp’s proposal would eliminate the current corporate rate structure, which ranges from 15 to 35 percent. In place of the current structure, the proposal calls for a flat 25 percent rate, phasing in the reduced rate through a two percentage point yearly reduction over five years.
Cost Recovery, Business Tax Credit, and Business Property Disposition Changes
The proposal would change when many business expenses can be deducted. The most significant changes would be in the cost recovery system that applies to most depreciable property and in the treatment of the costs of advertising, but other changes may be very significant for affected industries.
The proposal would repeal the MACRS depreciation system and require that the costs of tangible property be recovered on a straight-line basis over their “class life.” Nonresidential and residential real property and any section 1245 property which is real property without a class life would be recovered over 40 years. A taxpayer will be permitted to increase its cost recovery deduction by an amount equal to the product of the modified adjusted basis of the property and an “inflation adjustment percentage.” The modified adjusted basis is the adjusted basis as determined without taking into account the additional cost recovery deduction for inflation. The inflation adjustment percentage is the C-CPI-U for the calendar year preceding the calendar year for which the deduction is claimed. The proposed statutory language says that the deduction under subsection (a) (the deduction computed on the straight-line basis), after any increase for the inflation adjuster, shall not exceed the adjusted basis of such property determined as of the beginning of the year. Thus, the inflation adjustment appears to accelerate when cost recovery allowances are taken but not allow total cost recovery allowances in excess of the initial unadjusted basis of property. The new system would apply to property placed in service after 2016.
The proposal would set class lives for certain assets, such as semi-conductor manufacturing equipment (five years), qualified technological equipment (5), automobiles and light purpose trucks (5), rent-to-own property (9), telephone switching equipment (9.5), railroad track (10), smart electric distribution property (10), airplanes (12), natural gas gathering line (14), fruit tree or vine (20), telephone distribution plant (24), and water treatment and utility property (50). The legislation instructs Treasury to determine, and develop a schedule of, the economic depreciation of major categories of depreciable property and report no later than December 31, 2017, to the Ways and Means and Finance Committees. The adjusted schedules would take effect with respect to property placed in service after the end of the first calendar year ending after the calendar year during which the schedule is submitted.
The proposal would continue small business expensing at 2008-2009 levels. Small businesses could expense up to $250,000 in investments in new equipment and property with the deduction phased out for investments exceeding $800,000.
In provisions that target the oil and gas industry, percentage depletion would be repealed and the exception in the passive loss rules for working interests in oil and gas would be eliminated.
The deduction for income attributable to domestic production activities would be phased out.
The amortization period for costs of goodwill and certain other intangible assets, including mortgage servicing rights, would be extended from 15 years (nine years in the case of mortgage servicing rights) to 20 years.
Environmental remediation costs would be amortized over a 40-year period.
The various provisions of the Code relating to start-up and organizational expenses would be combined in one provision that would allow the first $10,000 to be expensed (with a phase-out beginning at $60,000) and the remainder to be amortized over 15 years.
The proposal would apply the regular depreciation system to property now subject to special cost recovery rules, including pollution control facilities, qualified property used for processing liquid fuel from crude oil or qualified fuels, energy-efficient commercial building property, and advanced mine safety equipment. The provision allowing farmers to deduct currently expenditures for fertilizer, lime, ground limestone, marl or other materials would be repealed as would be the expensing of the first $10,000 of reforestation expenditures.
The proposal would require certain expenditures that are currently deductible when paid or incurred to be amortized over a period of time including:
- Advertising expenses (50 percent currently deductible and 50 percent amortized ratably over 10 years). Advertising expenses would include wages paid to employees primarily engaged in activities relating to advertising and the direct supervision of employees engaged in such activities.
- Circulation expenses (36 months).
- Research and experimental expenditures (five years, using a mid-year convention (i.e., 10 percent, 20 percent, 20 percent, 20 percent, 20 percent, 10 percent over six years)).
- Soil and water conservation expenditures and endangered species recovery expenditures (costs would be capitalized in basis of underlying property).
- Qualifying film and television production expenses (costs generally would be recovered through depreciation using the income forecast method).
No deduction would be allowed for entertainment, amusement or recreational activities, facilities or membership dues relating to such activities or other social purposes. The current law 50 percent deduction would apply only to expenses for food and beverages and qualified business meals. No deduction would be allowed for reimbursed entertainment expenses paid as part of a reimbursement arrangement with a tax-indifferent party, such as a foreign person or entity exempt from tax. The deduction for transportation fringe benefits also would be repealed.
The proposal would change provisions relating to gains recognized from certain sales and dispositions, including:
- Repealing deferral of gain on like-kind exchanges and tightening the rules for deferring gain in the case of involuntary conversions.
- Repealing special rules that allow certain gain from cutting timber for sale and the disposal of timber, coal or iron ore to be treated as capital gain.
- Repealing rules allowing tax-free rollovers of publicly traded securities gain into specialized small business investment companies.
- Terminating special rules for gain from certain small business stock.
- Treating gain or loss from a self-created patent, invention, model or design, secret formula or process as ordinary.
- Repealing the provision treating gain from the sale of a patent before its commercial use as capital gain.
- Subjecting all post-2014 depreciation on real property to recapture as ordinary income.
The proposal would modify the research tax credit and the low-income housing tax credit and repeal almost all other business credits. On the chopping block are credits for alcohol used as fuel, biodiesel and renewable diesel used as fuel, enhanced oil recovery, electricity produced from renewable resources, Indian employment, Social Security taxes paid with respect to employee tips, clinical testing expenses for orphan drugs, small employer pension plan startup costs, employer paid child care, railroad track maintenance, production of low sulfur fuel, production of oil and gas from marginal wells, production from advanced nuclear power facilities, production of fuel from nonconventional sources, construction of qualified new energy-efficient homes, energy efficient appliances, mine rescue team training, chemical security expenditures incurred by qualifying agricultural businesses, carbon dioxide sequestration, employee health insurance expenses, qualified rehabilitation expenses, qualifying advanced coal projects, qualifying gasification projects, investments in qualifying advanced energy property, qualifying therapeutic discovery projects, and certain qualified wages paid to target populations (work opportunity tax credit). Some of these credits have expired. Most other credit would be repealed effective for tax years beginning after 2014 or for expenditures incurred after 2014. A minor transition rule would apply to the rehabilitation tax credit. The energy credit also would be repealed, but only for property placed in service after 2016.
Derivatives and Hedges
Drawing from Camp’s 2013 financial products discussion draft, derivatives would generally be marked to market at the end of each tax year with gains or losses treated as ordinary income or losses. The change would not apply to transactions identified as hedges, transactions requiring physical delivery of commodities or transactions that are “commercial” instead of financial or non-speculative in nature. For offsetting financial positions that include at least one derivative position, all positions in the straddle would be marked to market. The provision would be effective for tax years ending after 2014, in the case of property acquired and positions established after 2014, and for tax years ending after 2019, in the case of any other property or position.
The proposal also modifies the hedging rules to allow taxpayers to identify a transaction as a hedge for tax purposes if they have made the identification for financial accounting purposes. The provision would modify the hedging tax rules so that the rules would apply when an insurance company acquires a debt instrument to hedge risks relating to assets that support the company’s ability to honor future insurance claims. The provision would be effective for hedging transactions entered into after 2014.
Treatment of Debt Instruments
The proposal includes several provisions that would make modifications to the treatment of certain debt instruments. Purchasers of bonds at a discount on the secondary market would be required to include the discount in taxable income over the post-purchase life of the bond, rather than only upon retirement of the bond or resale of the bond by the purchaser. Any loss that results from the retirement or resale of such a bond would be treated as an ordinary loss to the extent of previously accrued market discount. The provision would limit the taxability of the discount to an amount that approximates increases in interest rates since the loan was originally made. The provision would be effective for bonds acquired after 2014.
Additionally, the issue price of a modified debt instrument generally would be equal to the lesser of (1) the issue price of the debt instrument before it was modified, or (2) the stated principal amount of the modified debt instrument. In addition, the holder of a debt instrument generally would not recognize taxable gain or loss as a result of modifying a debt instrument. The provision would be effective for debt modifications that occur after 2014.
Further, under the proposal, fees and other amounts received by a taxpayer would not be treated as OID income if the taxpayer is on the accrual method of accounting and includes an item of income no later than the tax year in which such item is included for financial statement purposes. The provision would be effective for tax years beginning after 2014.
Certain Rules for Determining Gain and Loss
The proposal contains several specific rules for determining gains and losses on certain financial products. Taxpayers who sell a portion of their holdings in substantially identical stock generally would be required to determine their taxable gain or loss on a FIFO basis. The provision generally would coordinate the recently enacted basis reporting requirements so that taxpayers could continue to determine basis in their stock on an account-by-account basis, except that multiple accounts with the same broker would be aggregated and treated as a single account. The provision would be effective for sales of stock occurring after 2014.
Separately, losses from the disposition of stock or securities also would be disallowed if certain parties that are closely related to the taxpayer acquire substantially identical stock or securities within 30 days before or after the disposition. If a loss has been disallowed under the provision and the taxpayer reacquires substantially identical stock or securities during the period that begins 30 days before the disposition and ends with the close of the first tax year that begins after the disposition, then the basis of the reacquired stock or securities would be increased to reflect the disallowed loss. The provision would be effective for sales of stock or securities occurring after 2014.
Finally, under the proposal, a corporation generally would not recognize income, gains, losses, or deductions with respect to derivatives that relate to the corporation’s own stock, except in limited circumstances. The provision would require a corporation to recognize income to the extent that the receipt of a contribution of money or property exceeds the value of stock issued in exchange for such money or property, and also would require a corporation to recognize income from the receipt of any premium received with respect to an option on its own stock. The provision would be effective for transactions entered into after the date of enactment.
Excise Tax on Systemically Important Financial Institutions, Limitation on FDIC Premiums Deduction
Under the proposal, the largest financial institutions, including U.S. banks and insurance companies, would be forced to pay a quarterly 0.035 percent excise tax on the total consolidated assets of the firm that are in excess of $500 billion. The excise tax would only apply to financial institutions that the 2010 Dodd-Frank law defines as being systemically important financial institutions (SIFIs). The $500 billion threshold would be adjusted in the coming years relative to increases in GDP. The JCT estimates that this excise tax on SIFIs will raise $86.4 billion in revenues over the next 10 years.
The proposal also modifies the deduction for contributions to the FDIC’s Deposit Insurance Fund. Banks pay into the fund each year, and the monies are used to manage insolvent institutions that are taken into receivership by the FDIC. Under the proposal, banks with total consolidated assets of more than $10 billion would see a prorata reduction in their deduction based on their asset size. Under the ratio calculation, banks above $50 billion in total consolidated assets would not be entitled to any deduction at all. The provision would take effect for tax years beginning after 2014. The JCT estimates the loss of this deduction would raise $12.2 billion over the next 10 years.
Establishment of Exemption System
The proposal would replace the current U.S. system of taxing the income earned by foreign subsidiaries only when such earnings are repatriated to the United States with a dividend exemption approach that exempts from U.S. income tax 95 percent of the income earned and distributed by a foreign subsidiary to a 10 percent or greater U.S. shareholder. This effectively results in a 1.25 percent tax on repatriated overseas earnings (once the new 25 percent corporate rate is fully phased in). As a result, no foreign tax credit or deduction for foreign income taxes paid could be claimed for any exempted dividend.
The proposal would further strengthen existing “thin capitalization” rules to restrict a U.S. corporation’s deduction of interest payments to related foreign parties by the lesser of the extent to which (1) the indebtedness of the U.S. parent exceeds 110 percent of the combined indebtedness of the worldwide affiliated group (including both related domestic and related foreign entities), or (2) where a U.S. company’s debt-to-equity ratio exceeds 1.5 to 1, by eliminating the tax deduction on excess interest (interest expense less interest income that is in excess of 40 percent of the taxpayer’s adjusted taxable income) as well as eliminating the carry forward of any disallowed interest deductions.
Currently, payments of fixed or determinable, annual or periodical (so-called “FDAP”) income –including interest, dividends and rents – to foreign persons are subject to a flat 30 percent U.S. withholding tax. Income tax treaties between the United States and other countries, however, often reduce or eliminate this withholding tax for payments from one treaty country to residents of another treaty country. The proposal would restrict the reduction or elimination of withholding by treaty in the case of deductible FDAP payments that are made by a U.S. subsidiary of a foreign parent to another subsidiary in a different treaty country that is controlled by the same foreign parent, unless the foreign parent could have received the FDAP payment directly from its U.S. subsidiary with reduced or eliminated withholding under an applicable treaty.
Working in connection with the new dividend exemption approach, the proposal would require a U.S. parent to reduce the basis of its stock in a foreign subsidiary by the amount of any exempted dividends received by it from its foreign subsidiary solely for purposes of determining the amount of a loss (but not gain) on a sale or exchange of the foreign subsidiary stock by its U.S. parent. Under current law, any gain that is recognized by a U.S. parent corporation on the sale or exchange of its stock in a foreign subsidiary generally is treated as a dividend distribution by the foreign subsidiary to its U.S. parent to the extent of un-repatriated earnings and profits earned by the foreign subsidiary while owned by the U.S. parent.
The proposal also would require a U.S. corporation that transfers substantially all of the assets of a foreign branch to a foreign subsidiary to include in income the amount of any losses previously incurred by the branch to the extent the U.S. corporation receives exempt dividends from any of its foreign subsidiaries.
In connection with the move to a dividend exemption approach, a U.S. shareholder owning at least 10 percent of a foreign subsidiary would include in income its pro rata share of the foreign subsidiary’s previously un-taxed foreign earnings. Earnings consisting of cash and cash equivalents would be taxed at a special rate of 8.75 percent, while any remaining E&P that is reinvested in the foreign subsidiary’s business would be taxed at a lower 3.5 percent rate. Foreign tax credits could be claimed by the U.S. shareholder to offset the U.S. tax. To minimize liquidity issues associated with the transition, the lower tax rate would apply to reinvested earnings and taxpayers would be permitted to elect to pay this transition tax liability over a period of eight years.
The proposal would make permanent the “look-through” rule that permits passive (dividends, interest, royalties, and rents) income to be received by a foreign subsidiary from a related foreign subsidiary without the U.S. parent being required to include such passive income in U.S. income currently whether or not distributed to the U.S. parent.
Foreign Tax Credits
As noted above, under the proposal, no foreign tax credit or deduction for foreign income taxes paid could be claimed for any exempted dividend. However, a foreign tax credit would be allowed for certain income of its foreign subsidiaries (“subpart F income”) that is included in the income of the U.S. shareholder on a current year basis, without regard to pools of foreign income kept offshore.
Under current law, a portion of expenses incurred in the United States by a U.S. parent of a foreign subsidiary that are not directly attributable to income earned by the foreign subsidiary must be allocated against foreign-source income for purposes of calculating the U.S. parent’s foreign-source income. This rule limits the amount of foreign tax credits a U.S. parent may use to reduce its U.S. income tax on foreign–source income. Under the proposal, only expenses that are directly attributable to income earned by the foreign subsidiary would be allocated against foreign-source income for purposes of calculating the U.S. parent’s foreign-source income and corresponding foreign tax credits. Directly allocable deductions include items such as salaries of sales personnel, supplies, and shipping expenses directly related to the production of foreign-source income.
Currently, foreign tax credits are separated into two baskets: active and passive. The passive basket includes (but is not limited to) dividends, rents, royalties, and capital gains. The proposal would expand the passive basket to include certain related-party sales income, foreign intangible income and the current-law passive income. The active basket would include all other income.
The proposal would modify the source rules for inventory property that is produced within the United States and sold outside the United States (or vice versa). Under the proposal, such inventory property would be allocated and apportioned between sources within and outside the United States solely on the basis of the production activities with respect to the inventory. Under current law, up to 50 percent of the income from the sale of such property may be treated as foreign-source income, even though the production activities take place entirely within the United States.
Passive and Mobile Income
As discussed above, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on its subpart F income (generally, dividends, interest, rents, royalties, and certain related-party sales or services transactions), regardless of whether or not the income is distributed to the U.S. parent. If, however, the subpart F income has been taxed at a rate that is at least 90 percent of the U.S. tax rate, the U.S. parent may elect to treat that income as non-subpart F income. The new provision would increase that threshold to 100 percent for foreign personal holding company income. However, the proposal would reduce the threshold to 50 percent for foreign base company sales income and to 60 percent for foreign base company intangible income. In addition, such treatment would no longer be elective.
Subpart F income includes foreign base company sales income, which is defined to include income earned by a foreign subsidiary from certain related-party sales transactions. Those related-party sales transactions include income earned by a foreign subsidiary from buying or selling personal property from or to, or on behalf of, related persons if the property is (1) manufactured, produced, grown or extracted outside of the country in which the foreign subsidiary is organized, and (2) used, consumed, or disposed of outside of such country. The proposal would eliminate income earned by a foreign subsidiary that is incorporated in a country that has a comprehensive income tax treaty with the United States, or to income that has been taxed at an effective tax rate of 12.5 percent or greater thereby limiting the types of related-party sales income that would be taxable currently to a U.S. parent.
The subpart F rules currently include a de minimis rule that states that if the gross amount of such income is less than the lesser of five percent of the foreign subsidiary’s gross income or $1 million, then the U.S. parent is not subject to current U.S. tax on any of the income. The proposal would adjust the $1 million for inflation.
For tax years of foreign subsidiaries beginning before 2014, and tax years of U.S. shareholders in which or with which such tax years of the foreign subsidiary end, there was a temporary exception for certain types of subpart F income (dividends, interest, royalties, rentals, and other types of passive income – “foreign personal holding company income”) if such income was derived in the active conduct of a banking, financing, or similar business, or in the conduct of an insurance business (“active financing income”). The new provision would extend the exception for five years for active financing income that is subject to a foreign effective tax rate of 12.5 percent or higher. Other active financing income would be subject to a reduced U.S. tax rate of 12.5 percent, before the application of any foreign tax credits.
Foreign shipping income earned between 1976 and 1986 was not subject to current U.S. tax under subpart F if the income was reinvested in certain qualified shipping investments. Such income did become subject to U.S. tax in subsequent taxable years to the extent there was a net decrease in qualified shipping investments during such subsequent year. The proposal would effectively eliminate the imposition of U.S. tax on such previously excluded foreign shipping income.
Under current law, if a foreign subsidiary of a U.S. parent owns intangible property in a foreign jurisdiction, the U.S. parent may allocate profits to the foreign subsidiary, which may permit the U.S. parent to defer U.S. tax on those profits until they are distributed to the U.S. parent. The proposal would add a new category of subpart F income, “foreign base company intangible income,” such that a U.S. parent of a foreign subsidiary would be subject to current U.S. tax on the excess of the foreign subsidiary’s gross income over 10 percent of the foreign subsidiary’s adjusted basis in depreciable tangible property. The U.S. parent could claim a deduction equal to a percentage of the foreign subsidiary’s foreign base company intangible income that relates to property that is sold for use, consumption, or disposition outside the United States or to services that are provided outside the United States. A U.S. corporation would also be permitted a deduction for such income if earned directly. The deductible percentage would phase-in at 55 percent for tax years beginning in 2015 and stabilize at 40 percent for tax years beginning in 2019 or later.
Although corporations currently are permitted to deduct all of their interest expense even if the debt was acquired to capitalize a foreign subsidiary, the expense allocation rules require the interest expense to be allocated against foreign source income (limiting the amount of foreign tax credits the U.S. parent may utilize). The proposal would reduce the deductible net interest expense of a U.S. parent of one or more foreign subsidiaries to the extent to which (1) the indebtedness of the U.S. parent (including other members of the U.S. consolidated group) exceeds 110 percent of the combined indebtedness of the worldwide affiliated group, or (2) net interest expense exceeds 40 percent of the adjusted taxable income of the U.S. parent.
The S corporation provisions in the bill address complexities applicable to S corporations under current law, eliminate penalties for inadvertent errors, simplify certain rules, and reduce certain tax burdens.
The bill would ease the penalties on S corporations that were previously C corporations. It would make permanent the five-year period (previously 10 years) during which such S corporations are taxed at the highest corporate rate on certain built-in gains property held while operating as a C corporation. It would repeal the provision terminating the S election of such corporations for excessive passive income. If more than 60 percent of the gross receipts of a former C corporation is attributable to passive income, the S corporation would be subject to corporate tax on the passive income.
The proposal would apply the charitable contribution deduction rules that apply to individuals to “electing small business trusts” that are shareholders of S corporations. The pre-2014 rule on basis adjustments for charitable contributions of property would apply, meaning that a shareholder’s basis would be reduced by the adjusted basis, not fair market value, of the contributed property.
The proposal would allow corporations to elect S corporation status on its income tax return for the year to which the election relates.
The proposed changes in taxation of partnerships were generally drawn from Option 1 of the Ways and Means Committee’s March 12, 2013 discussion draft. The proposal would narrow the rule allowing certain publicly traded partnerships to be treated as partnerships rather than corporations for tax purposes and treating “carried interest” allocations as ordinary income.
Under the carried interest provision, certain partnership interests held in connection with the performance of services would be subject to rules that characterize a portion of any capital gains from allocations of income or the disposition of the interest as ordinary income. The provision appears to be different from provisions included in various carried interest bills introduced in the last few years. First, it would not apply to a partnership engaged in a real property trade or business. Second, it would “treat the service partner’s applicable share of the invested capital of the partnership as generating ordinary income by multiplying that share by a specified rate of return (the Federal long-term rate plus 10 percentage points), intended to approximate the compensation earned by the service partner for managing the capital of the partnership.” The recharacterization amount would be determined on annual basis. Capital contributions by a service partner would reduce the amount of capital gain recharacterized as ordinary income. Any allocation of income from the partnership or gain from the sale of a partnership interest then would be treated as ordinary to the extent of the partner’s recharacterization account balance for the taxable year.
The bill would repeal the rules relating to guaranteed payments. Payments to partners would either be payments in their capacity as partners (part of their distributive share of partnership income) or in their capacity as an independent third party. The bill would also repeal the provision treating certain liquidating payments to retiring or deceased partners as guaranteed payments. Mandatory adjustments of a partner’s basis in a partnership would be required when a partner transfers an interest in a partnership or a partnership distributes property. Any distribution of an inventory item would be treated as a sale or exchange between the partner and a partnership. The bill attempts to simplify the definition of unrealized receivable (often referred to as a “hot asset”) by treating property other than inventory as a hot asset only to the extent of the amount that would be treated as ordinary income if the property were sold at fair market value.
The bill would require partners to take into account their shares of a partnership’s charitable contributions and foreign taxes paid in calculating the limitation on the partner’s share of losses.
Under the proposal, a partner who contributes property with built-in gain or loss to a partnership would be required to recognize the pre-contribution gain or loss when the partnership distributes the property. The seven-year limitation on this rule would be repealed.
The proposal would repeal the technical termination rules of section 708 of the Code. A partnership would be treated as continuing even if more than 50 percent of the interests in the partnership are sold and exchanged.
The proposal tightens the exception to the general rule that a publicly traded partnership is treated as a corporation for tax purposes. The exception would apply only if at least 90 percent of the partnership’s income derives from activities relating to mining and natural resources.
REITS and RICs
The bill includes provisions related to REITs that are designed to discourage the erosion of the corporate tax base. Other provisions would make traditional REITs easier to operate. The more significant provisions are identified below.
The bill would overturn a 2001 IRS ruling and prohibit REITs from satisfying the active trade or business requirement for a tax-free spinoff. It also would prohibit a distributing corporation and a controlled corporation in a spinoff from qualifying as a REIT for 10 years following a tax-free spin-off. As an anti-avoidance measure, the bill states that the provision would be effective for distributions after February 26, 2014. In another provision with a similar effective date, the bill would require REITs to distribute their pre-REIT C corporation earnings and profits in cash, rather than property or stock, by the end of the first tax year after becoming a REIT. Also effective, February 26, 2014, the current entity level tax on built-in gain would be imposed at the time a C corporation elects to become a REIT or RIC or transfers assets to a REIT or RIC in a carryover basis transaction. That effective date would also apply to a provision denying the deduction for dividends received from a foreign subsidiary to dividends that are attributable to dividends received by the foreign subsidiary from a RIC or REIT.
The bill would extend from five to 10 years the period that an entity that terminated its REIT status must wait before re-electing REIT status and would change the definition of real property for the REIT income tests to exclude tangible property with a class life of less than 27.5 years and to exclude timber. The bill also would exclude from rents for real property and interest amounts determined based on a fixed percentage of receipts or sales to the extent they are received from a single tenant that is a C corporation and the amounts received or accrued from the tenant constitute more than one quarter of the total amount received or accrued by the REIT that is based on a fixed percentage of receipts or sales.
The proposal would permit taxable REIT subsidiaries to operate foreclosed real property and develop and market REIT real property. It would expand the 100-percent excise tax on non-arm’s length transactions to cover services provided by a TRS to its parent REIT.
The FIRPTA exception for interests in U.S. corporations that have disposed all of their interests in U.S. real property in taxable transactions during the five-year period preceding disposition of an interest in the U.S. corporation by a foreign person would not apply to interests in REITs or RICs that disposed of their interests in U.S. real property with respect to which the REIT or RIC claimed a dividends paid deduction.
The bill would make a variety of changes to accounting rules for determining taxable income. The most significant changes would be to eliminate LIFO and lower-of-cost-or-fair-market value rules, require large service partnerships to use the accrual method, and require greater consistency with financial accounting. Some, but not all, of the accounting changes are discussed below.
The bill would require businesses, including services businesses, such as law firms and medical practices, with average annual gross receipts of $10 million to use the accrual method of accounting. Businesses with average annual gross receipts below that threshold would be permitted to use the cash method. Farming businesses and sole proprietorships would be exempt from the requirement to use the accrual method. Positive income adjustments resulting from a mandated change in accounting could be spread over four years beginning in 2019, even though the provision would be effective for tax years beginning after 2014.
The proposal would require a taxpayer on the accrual method of accounting for tax purposes to include an item in income no later than the tax year in which such item is included for financial statement purposes. Cash and accrual method taxpayers would be permitted to defer the inclusion of advance payments for certain goods and services in income for up to one year, but not longer than any deferral for financial statement purposes. Certain special exceptions would be repealed.
The bill would prohibit use of the LIFO inventory accounting method. A taxpayer would be required to include its LIFO reserve income over a four-year period beginning with its first tax year beginning after 2018. Closely held entities would be subject to a reduced seven percent tax rate on their LIFO reserves. This change increases revenues by $79.1 billion over 10 years according to the JCT. The bill would also repeal the lower-of-cost-or-market method and provide a four-year inclusion period for positive adjustments.
The bill would expand the exception to the UNICAP rules for businesses with average annual gross receipts of $10 million or less to include acquisitions of all types of property, whether produced or acquired by the taxpayer. Special rules for timber and trees, free-lance authors, photographers and artists would be repealed.
In the case of an installment sale in excess of $150,000, the seller would have to pay interest charges to the IRS if the obligation is outstanding at the end of the tax year. Under current law, interest charges apply only if the taxpayer’s installment sales exceed $5 million.
The bill would repeal a variety of special accounting rules, including ones for averaging of farm income, prepaid subscriptions, prepaid membership dues, and magazines, paperbacks, and records returned after the close of the year. The advance payment rule described above would apply to subscriptions and membership dues.
The proposal would limit the use of the completed-contract method of accounting to contracts to be completed within two years for taxpayers with average gross receipts of $10 million or less and would repeal the special exceptions to the percentage-of-completion method rules for multi-unit housing contracts and ship building contracts.
The Camp proposal would replace the current individual income tax structure by collapsing its seven marginal rate brackets (which range from 10 to 39.6 percent) to three brackets: 10, 25, and 35 percent. The 35-percent bracket would be composed of two separate calculations: a 25-percent tax on taxable income above a specified threshold and a 10 percent surtax on modified adjusted gross income (MAGI), defined as adjusted gross income (AGI) with adjustments for deductions and exclusions (as discussed below), above a specified threshold. The 10-percent bracket would apply to taxable income up to $71,200 for joint returns and surviving spouses ($35,600 for all other filers). The 25-percent bracket would apply to taxable income from $71,200 ($35,600) to $450,000 ($400,000 for all other filers).
MAGI income is a significantly broader base of income than AGI and this provision would therefore apply to a broader swath of taxpayers than it would under a more traditional AGI calculation for items such as Pease deduction limitations. The effect of this is to limit many tax preferences to a 25 percent rate level for taxpayers in the 35-percent bracket. The bracket income thresholds would be adjusted for inflation annually.
In addition, unlike current law, the benefit of the 10-percent bracket would begin to be phased out for individuals with MAGI above $300,000/$250,000, generally culminating at full phase out for those with MAGI at or exceeding $513,600 (joint filers) or $356,800 (individual taxpayers). Functionally, this provision operates as an additional five percent surtax on MAGI income between $300,000 and $513,600.
Estates and trusts have only two brackets: 25 and 35 percent, with the 35-percent rate composed of a 25-percent rate on taxable income and an additional 10-percent rate on MAGI above $12,000.
For purposes of the 35-percent bracket calculation and the phaseout of the 10-percent bracket for upper income individuals, MAGI is defined as AGI (which is income before itemized or the standard deduction) plus:
(i) any amount excluded from income under sections 911 (related to exclusions from income for citizens or residents of the United States living abroad), 931, and 933;
(ii) any amount of interest received or accrued by the taxpayer during the taxable year which is exempt from tax (less any amounts disallowed as a deduction for investment interest with respect to tax-exempt interest, and amortizable bond premiums on tax-exempt bonds);
(iii) any amount excluded by the taxpayer as a cost of employer-sponsored health coverage;
(iv) amounts paid by a self-employed individual for health insurance deducted under section 162(l);
(v) pre-tax contributions to tax-favored defined contribution retirement plans;
(vi) deductible health savings account (“HSA”) contributions; and
(vii) excluded Social Security and tier I railroad retirement benefits.
(i) charitable contributions to the extent eligible for a deduction under section 170, but only if the taxpayer itemizes his or her deductions; and
(ii) qualified domestic manufacturing income (QDMI), which for these purposes is defined as domestic manufacturing gross receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those receipts; and (2) other expenses, losses, or deductions which are properly allocable to those receipts.
The Camp proposal would also require the use of the chained CPI-U (C-CPI-U) to index tax parameters currently indexed by the CPI-U. The chained CPI is a slower inflation adjustment than is CPI-U, meaning that under the proposal the income limits for the various tax brackets and associated phase outs would rise more slowly than under current law.
Capital Gain and Dividend Income
Under the proposal, individuals would be taxed on capital gains and dividends at ordinary income rates, but would receive an above-the-line deduction for 40 percent of adjusted net capital gain, defined as the sum of net capital gain and qualified dividends, reduced by net collectibles gain.
Therefore, the effective top rate for capital gains and dividends would be 21 percent (.60)(.35), plus the 3.8 percent tax in certain investment income enacted as part of PPACA, for a total effective rate of 24.8 percent, which is similar to the effective top rate under current law.
The proposal increases the standard deduction for taxpayers across all filing statuses. Under the proposal, the amount of the standard deduction is $22,000 for married individuals filing a joint return and $11,000 for all other taxpayers (the proposal eliminates head of household filing status). The amount of the standard deduction is indexed for inflation using the chained CPI.
The proposal also provides that the amount of the standard deduction is phased out by 20 percent of every dollar that a taxpayer’s MAGI exceeds $513,600 for joint filers ($356,800 for all other filers). Thus, the standard deduction would be completely phased out for taxpayers with MAGI at or above $623,600 (joint filers) and $411,800 (all other filers). The threshold amount at which the phaseout begins is indexed for inflation.
The proposal also phases out up to $22,000 of deductions (joint filers) or $11,000 (for all other filers) for taxpayers who choose to itemize their deductions over the same MAGI range.
For example, if a married taxpayer has MAGI of $625,000 and $50,000 in itemized deductions, those deductions would be reduced to $28,000. A taxpayer with MAGI of $550,000 and $50,000 in deductions would see their deductions reduced by $7280 to $42,720.
The proposal also eliminates the additional standard deduction for the aged and the blind, and provides for an additional above-the-line deduction of $5,500 (indexed for inflation) for unmarried individuals with at least one qualifying child, which is phased out for every dollar by which a taxpayer’s AGI exceeds $30,000 (this threshold is also adjusted for inflation).
The proposal would repeal both the individual and corporate AMT effective 2015. Any remaining AMT credit carryforwards would be refunded at 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2016, 2017, and 2018. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2019.
Notable Additional Individual Modifications
While the discussion draft would make numerous additional modifications to the taxation of individuals, several proposals are particularly noteworthy, including modifications to the mortgage interest deduction, changes related to the treatment of charitable contribution, and repeal of the deduction for State and local taxes.
In addition to effectively limiting the mortgage interest deduction to a 25 percent benefit level, the proposal would, in four annual increments, further limit the mortgage interest deduction on new mortgages to interest attributable to $500,000 in acquisition indebtedness, rather than $1 million under current law. Under the incremental limitation framework the limitation for debt incurred would be: $875,000 in 2015; 750,000 in 2016; $625,000 in 2017; and $500,000 thereafter. Under the proposal, interest paid on home equity indebtedness incurred after 2014 is not treated as qualified residence interest, and thus is not deductible.
The Camp proposal makes a number of significant changes with regard to charitable contributions. For example, under the provision an individual’s charitable contributions could be deducted only to the extent they exceed two percent of the individual’s AGI. Further, the current-law AGI limitations on deductible contributions would be changed by harmonizing the 50-percent limitation for cash contributions and the 30-percent limitation for contributions of capital gain property to public charities and certain private foundations at a single limit of 40 percent. Second, the 30-percent contribution limit for cash contributions and the 20-percent limitation for contributions of capital gain property that apply to organizations not covered by the current 50-percent limitation rule would be harmonized at a single limit of 25 percent. Thus, contributions to this latter group of organizations would be allowed to the extent they do not exceed the lesser of (1) 25 percent of AGI or (2) the excess of 40 percent of AGI for the tax year over the amount of charitable contributions subject to the 25-percent limitation.
The proposal would allow taxpayers to deduct charitable contributions made after the close of a year but before the due date for a tax return. The special rule that provides a charitable deduction of 80 percent of the amount paid for the right to purchase tickets for athletic events would be repealed. The rules for valuing deductions for contributions of property would be modified.
The proposal also would repeal the deduction for State and local taxes, suggesting that this negates a benefit that subsidizes higher State and local taxes and increased spending at the State and local level.
Pensions and Retirement Accounts
Chairman Camp’s tax reform plan contains a variety of proposals to streamline and simplify the retirement savings vehicles available to American workers and their families while generating over $226 billion in increased revenue over the next 10 years. The most significant proposal would limit the amount of pre-tax contributions to traditional 401(k) plans to half of the current maximum employee contribution (currently $17,500, plus a $5,500 catch-up contribution for those 50 years and older). The remainder could be contributed, after-tax, to Roth accounts, which all 401(k) plans would be required to provide. This change would not apply to small employers (i.e., those with 100 or fewer employees) but would enable Savings Incentive Match Plan for Employees (SIMPLE) IRAs to offer a Roth option. It also would increase the annual contribution limit for SIMPLE IRAs (currently $12,000 plus a $2,500 catch-up contribution) to the same level as 401(k) plans if the employer sponsoring the SIMPLE IRA limits pre-tax contributions to half of the annual contribution limit (allowing the remainder to be contributed, after-tax, to the newly-permitted Roth Accounts). This proposal, on its own, is expected to increase revenue more than $143 billion between 2014 and 2023.
The proposal promotes retirement savings through Roth accounts, particularly Roth IRAs, in other ways as well. First, it would eliminate the income eligibility limits for contributing to Roth IRAs, prohibit new contributions to traditional IRAs, and discontinue the use of non-deductible traditional IRAs. Second, the discussion draft would prohibit the conversion of Roth IRA contributions to traditional IRA contributions, but would continue to allow IRA owners to convert traditional IRA contributions to Roth contributions. Further, under the proposed plan, no new Simplified Employee Pension (SEP) IRAs, which generally may only accept employer contributions, or SIMPLE 401(k) plans could be established (though employers would be permitted to continue making contributions to existing SEPs and SIMPLE 401(k) plans).
The Camp proposal would freeze until 2024 existing inflation adjustments to annual contribution limits on Roth IRAs, defined contribution plans, SEPs, and SIMPLE IRAs, as well as the maximum benefit under a defined benefit plan. After 2024, inflation adjustments would begin again but would be based on the frozen level.
Additional modifications to the current retirement savings structure include the following:
- Repeal of the exception from the 10 percent tax penalty generally assessed for early distributions from a retirement plan where the early withdrawal is used to pay for first-time homebuyer expenses;
- Apply the 10 percent tax penalty for early distributions to State and local government 457(b) plans;
- Modify the required minimum distribution rules to, among other changes, require distributions to certain beneficiaries to be made within five years after the plan participant’s death;
- Reduce the minimum age for in-service distributions from State and local defined contribution plans and all defined benefit plans from 62 to 59½ (to match the minimum age applied to other defined contribution plans);
- Require the IRS, within one year of the date of enactment, to change existing guidance so that employees who take hardship distributions from their defined contribution plans can continue contributing to those plans (eliminating the requirement that they wait six months before doing so); and
- Align contribution limits for 403(b) and 457(b) plans so that they match the contribution limits for 401(k) plans.