On November 2nd, the Republicans in Congress released a proposed tax reform bill that is designed to cut taxes and simplify the tax code. The bill, titled the “Tax Cuts and Jobs Act,” has yet to pass the House of Representatives and be reconciled with a tax reform bill that is expected to be introduced by Senate Republicans. Also, the final version must be signed by President Trump to become law. However, the bill was referred to the House Ways and Means Committee and is considered to be a framework for the tax reform that is championed by the president.
Republicans hailed the bill as one that will be a framework for “more jobs, fairer taxes, and bigger paychecks.” The proposal calls for significant changes to the current tax structure and laws affecting the federal income taxation of individuals and businesses, as well as estate and international taxation. The proposed changes would represent the most comprehensive tax reform since 1986 when President Reagan overhauled the tax code. We present you with the most significant changes below.
Changes Affecting Individuals
The proposed bill would modify individual income tax rates and eliminate many itemized deductions, but provide a higher standard deduction amount. Some of the proposed changes for those married filing jointly are as follows:
Individual Income Tax Rates: The proposed legislation would consolidate the seven current income tax brackets into four: 12%, 25%, 35%, and 39.6%. Also, the highest tax bracket would only apply to those earning more than $1 million (up from the current $470,701). Also, the bill adds a 6% surcharge for those earning between $1.2 million and $1.4 million. Notably, the proposed legislation does not repeal the 3.8% net investment income tax.
Standard Deduction: The standard deduction would increase to $24,000 for joint filers (from the current $12,700) and $12,000 (from the current $6,350) for individual filers (indexed for inflation). The additional standard deduction that is currently available for seniors and the blind was also eliminated. Overall limitations on itemized deductions would be repealed.
State and Local Tax Deduction: The proposed bill eliminates the deduction of payments made to state and local governments for income taxes. However, taxpayers will still be able to deduct real property taxes paid on the primary home for up to $10,000.
Mortgage Interest Deduction: The home mortgage interest deduction would no longer be allowed for principal amounts up to $1 million and will be limited to $500,000 of principal for new home purchases. Besides, the interest deduction will no longer be available for home equity loans.
Other Deductions: Individuals would no longer be permitted to deduct, among other things, tax preparation expenses, medical expenses, and certain education costs. Also, a popular deduction used by rebbeim and teachers, known as the qualified tuition reduction, will no longer be available. In addition, the payer of alimony will no longer be able to shift the tax burden to the recipient.
Personal Exemptions: The proposed legislation would eliminate the personal and dependency exemptions.
Alternative Minimum Tax: The proposal would repeal the alternative minimum tax.
Gain on Sale of Home Exclusion: The “two of five” rule that excluded up to $250,000 ($500,000 for married taxpayers) in capital gains from the sale of your home would be changed to “five of eight.” That means that you must have owned and resided in the house for at least five of the last eight years in order to qualify for the exclusion.
Child Tax Credit: Currently, a refundable tax credit of $1,000 can be received for each child under 17. The proposed bill allows for an additional $600 nonrefundable credit for each child and $300 for each parent and non-child dependent. In addition, the child and dependent care credit will be eliminated.
Measure of Inflation: Currently, inflation is adjusted annually to protect taxpayers from paying higher tax rates because of increases in income due to inflation. The bill also provides for a modified measurement of inflation which will eventually result in pushing the middle class into higher tax brackets.
Changes Affecting Businesses
New Tax Rate on Closely-Held Business Income: Currently, the profits of closely-held business – including partnerships, limited liability companies, and Subchapter S corporations – flow through to the owners to be taxed at their individual income tax rates, which may be as high as 39.6%. The current bill provides that owners of such pass-through entities may be subject to a maximum rate of 25% on a portion of their income.
In order to avoid abuse and business owners classifying wages as income, only income that is treated as “business income” will qualify for the reduced rate with the remaining portion of income taxed at the owner’s individual income tax rate. “Business income” will have to be calculated using one out of two methods which may complicate the tax filings for small businesses. In addition, certain personal service businesses, such as firms providing legal, accounting, consulting, engineering and financial services, would generally be excluded from qualifying for the reduced 25% rate.
Bonus Depreciation: In an effort to encourage investments, the proposal would allow businesses to expense the cost of certain depreciable assets – or new plants and equipment – instead of depreciating those assets over their useful lives. This tax incentive will expire in five years.
Interest Expense Limitation: Businesses with average gross receipts of $25 million or more could lose the ability to deduct interest expense on bonds or debt. Under the proposal, interest expense would be limited to 30% of the adjusted business income reported by the company with any excess interest carried forward to be written off over a five year period.
Section 179 Depreciation: Section 179 enables small business to deduct the cost of new or used equipment and software instead of depreciating it over their useful lives. Under the proposal, the current deduction limit of $500,000 will be increased to $5 million (indexed for inflation). The current definition of a small business is one that spends less than $2.5 million on equipment during any given year. This limit would be increased to $20 million (indexed for inflation) before losing the deduction.
Net Operating Loss (NOL) Deduction: Currently, a business may deduct losses that may arise if deductions are greater than income. The deduction can generally be carried back two years or carried forward for 20 years and is subject to certain limitations. Under the proposal, the deduction of a net operating loss would be limited to 90% of income. In addition, the taxpayer would no longer have the option to carry back NOL deductions.
Extension of Holding Period on Promotes: The proposed bill would require a partner who received a promote interest in a partnership in connection with the performance of services or syndication to hold the investment for a three-year holding period in order to qualify for long-term capital gains.
Cash Method of Accounting: Under the proposed bill, more businesses will be able to file using the cash method of accounting versus the accrual-basis method of accounting. Accordingly, C corporations (and partnerships with a C corporation partner) and businesses that sell merchandise and have less than $25 million in average annual revenues will now be able to choose the cash method of accounting. This change will benefit businesses with a high working capital or whose accounts receivables routinely exceed its accounts payable.
Corporate Tax Rate: The proposal would eliminate the current corporate tax rate structure that has a maximum rate of 35% and replace it with a flat 20% corporate tax rate (or a 25% rate for personal service corporations).
Changes Affecting Estate Tax
The proposed bill also would immediately double the gift and estate tax exemption amount to $10 million (indexed for inflation). In 2024, the estate tax will be repealed in its entirety; however, the gift tax will remain. In addition, the step-up in basis of assets received from a decedent will continue to allow the heirs to value the assets at fair market value for tax purposes. Accordingly, no capital taxes will be incurred if the heirs will sell assets immediately after the death of the decedent.
What’s Next?
The next step is for the House of Representatives to debate the bill and vote on it. The Senate Finance Committee – who will release an independent tax bill – aims to finish its plan by November 10, 2017. The House and Senate must then reconcile the two bills. After reconciliation, the House and the Senate must vote on the final bill and send it to the president before the end of the year. If it doesn’t add more than $1.5 trillion to the national debt over the next ten years, it can pass the Senate with a 51-vote majority. Otherwise, it would require a 60-vote majority to pass, which would be unlikely given the Democratic opposition to the plan.
We will keep you updated as the legislative process moves forward.
