The Obama administration submitted a budget proposal on March 4 that includes new provisions that would expand the reach of self-employment taxes on professional service businesses, limit like-kind exchanges and raise $55 billion with new rules aimed to curb profit shifting.
The budget includes hundreds of proposed tax changes, but the overwhelming majority are recycled from previous budgets — including proposals to limit the benefit of deductions to 28%; impose a “Buffett Rule” minimum tax; repeal the last-in, first-out (LIFO) method of accounting; impose a “financial responsibility fee” on the liabilities of financial institutions; change the taxation of carried interest; and repeal tax benefits for oil, gas and coal producers. Several significant proposals, however, are new, including proposals to:
- Combat base erosion and profit shifting
- Allow greater information exchange on Foreign Account Tax Compliance Act (FATCA) information with foreign jurisdictions
- Expand the application of self-employment taxes to personal service business passthrough income
- Limit the annual gift tax exclusion in order to limit Crummey trust planning
- Conform the definition of “control” under Section 368 to the affiliation test under Section 1504
- Limit the adjustment of earnings and profit (E&P) in certain stock distributions
- Limit real estate like-kind exchanges to $1 million per taxpayer per year
- Repeal the telephone excise tax
- Grant the IRS authority to regulate return preparers
- Move the deadlines for filing partnership and C corporation returns
On balance, the tax proposals in the budget would raise more than $1 trillion in new revenue, but the administration said $248 billion of the revenue raisers and “loophole closers” are meant to be earmarked for revenue-neutral tax reform. The administration has proposed lowering the corporate rate to 28%, while using some of the short-term revenue from repealing tax expenditures to invest in infrastructure.
The administration said $248 billion of the revenue raisers and 'loophole closers' are meant to be earmarked for revenue-neutral tax reform.
The budget generally does not address the 55 popular “extender” tax provisions that expired at the end of 2013. It does, however, propose to expand and extend several specific extender provisions (including the research credit, new markets tax credit, energy-efficient home construction credit and the credit for cellulosic biofuel), but does not otherwise indicate whether the president supports allowing the other extender provisions to expire.
This president abandoned two notable proposals from last year’s budget: a 10% credit for employer wage increases and a proposed shift to the “chained” consumer price index (CPI) for most government inflation adjustments. The shift to chained CPI would have resulted in shallower inflation adjustments for tax provisions, but was unpopular with many congressional Democrats because of its effect on Social Security benefits. House Ways and Means Chair Dave Camp, R-Mich., recently proposed moving to chained CPI for the tax brackets as part of the tax reform discussion draft released on Feb. 26.
With a divided Congress and midterm elections approaching, few of the president’s tax proposals are likely to be enacted this year. But many of them could be considered in future tax reform discussions, and revenue-raising provisions are always a threat to be used to pay for other priorities. The following describes some of the more significant new proposals.
The budget would apply self-employment taxes to all pass-through income of individuals who materially participate in a professional service business. Under current law, the distributive share of S corporation income not received as salary is not subject to self-employment tax. In contrast, partners are generally subject to self-employment tax, but there are several exceptions, including for “limited partners” and real estate income.
Under the proposal, any partner or S corporation shareholder who materially participates in a professional service business would be subject to self-employment tax on all the income from the business. For partners or shareholders who do not materially participate, self-employment tax would apply only to any amount of “reasonable compensation.” Because all passthrough income from a trade or business in which a taxpayer does not materially participate is generally subject to the new 3.8% Medicare tax on net investment income (NII), the proposal would essentially result in all income from a professional service business to be subject to either self-employment tax or the tax on NII. Professional service businesses would be defined as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, brokerage services, and lobbying.
Section 368 definition of ‘control’
The budget would conform the test for common control under Section 368 to the affiliation test rule under Section 1504. Under the proposal, “control” for Section 368 would be defined as ownership of at least 80% of the total voting power or 80% of the total value of stock. Stock would not include certain preferred stock that meets the requirements of Section 1504(a)(4).
Prevent elimination of E&P through certain stock distributions
The proposal would amend the general rules for adjusting E&P when distributing the stock of another corporation to shareholders. Under the proposal, the distribution of another corporation’s stock would reduce the distributing corporation’s E&P by the greater of the stock’s fair market value or the corporation’s basis in the stock. The distributing corporation’s basis in the distributed stock would be determined regardless of any adjustments from actual or deemed dividend equivalent redemptions by the corporation whose stock is distributed, and regardless of any distributions or transactions undertaken to create and distribute high-basis stock of any corporation. Treasury would be granted regulatory authority to enforce the proposal.
Limiting real estate like kind-exchanges
The budget would limit the amount of capital gain that can be deferred under Section 1031 from the like-kind exchange of real property to $1 million (indexed for inflation) per taxpayer per year.
Limit on annual gift tax exclusion
The budget proposes a new limit on the annual gift tax exclusion (currently $14,000) that is aimed at curbing the Crummey trust planning technique (from the 1968 case Crummey v. Commissioner, 397 F.2d 82). Generally, a transfer to a trust qualifies for the annual exclusion from gift tax only if it is a present interest. The technique used in Crummey provided that short-term withdrawal rights allowed a transfer to qualify as a present interest. The budget would eliminate the present interest requirement and instead impose an annual limit on the gift tax exclusion of $50,000 per taxpayer for any transfers falling under a newly defined category. The new category of transfers would generally include transfers to a trust, transfers subject to a prohibition on sale, transfers of passthrough interests and other transfers of property that cannot be immediately liquidated.
The budget proposes to repeal the 3% excise tax on local access and toll telephone service. The IRS several years ago conceded that the excise tax does not apply to long-distance service or bundled services for a flat fee.
The president’s budget includes five new provisions intended to reduce base erosion and profit shifting that appear to have been at least partially inspired by efforts of the Organisation for Economic Co-operation and Development. Similar provisions have been proposed by former Senate Finance Committee Chair Max Baucus, D-Mont., and Camp. The budget also includes a new proposal to aid the implementation of FATCA. In addition, it replaces a proposal on earning stripping by expatriated entities with a broader proposal restricting interest deductions for members of a group filing a consolidated financial statement.
New subpart F category of digital goods and services
The budget would create a new category of subpart F income to account for income streams that do not fall under the traditional definition of subpart F. This new category, “foreign base company digital income,” would generally include income of a controlled foreign corporation (CFC) from the lease or sale of a digital copyrighted article or from the provision of a digital service. The category would apply when the CFC used the intangible property developed by a related party to produce the income and the CFC did not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income. An exception would apply if the CFC earned income directly from customers located in the CFC’s country of incorporation that used or consumed the digital copyrighted article or digital service in that country.
Expand definitions of FBCSI
The budget would expand the definition of “foreign base company sales income” (FBCSI) to include income of a CFC from the sale of property manufactured on behalf of the CFC by a related person. The administration expressed concern that taxpayers are taking the position that a CFC can avoid FBCSI by structuring a related-party transaction by which the CFC obtains the property that the CFC sells to customers as the provision of a manufacturing service to the CFC, rather than as a purchase of the property by the CFC.
Restrict hybrid entities
This proposal seeks to curb the use of hybrid arrangements that Treasury said are used to create stateless income. Treasury said the arrangements, which can consist of hybrid transfers like so-called “sales-repurchase” or “repo” transactions, enable taxpayers to take inconsistent positions regarding the ownership of the same item of property. The proposal would deny deductions for interest and royalty payments made to related parties under certain circumstances involving hybrid arrangements.
For example, the proposal would deny a deduction in the United States when a taxpayer makes an interest or royalty payment to a related party, and either (1) as a result of the hybrid arrangement, there is no corresponding inclusion of income to the recipient in the foreign jurisdiction; or (2) the hybrid arrangement would permit the taxpayer to claim an additional deduction for the same payment in another jurisdiction.
Limit subpart F exceptions for reverse hybrids
The budget would limit the “same country” and “CFC look-through” exceptions to subpart F for certain “reverse hybrid entities,” entities that are typically treated as corporations or CFCs for U.S. tax purposes and as fiscally transparent entities (such as a partnership) or branches in the foreign jurisdiction. The budget would provide that the same-country exception to subpart F income in Section 954(c)(3) and the look-through exception to subpart F income under Section 954(c)(6) would not apply to payments made to these “foreign reverse hybrids” held directly by a U.S. owner when such amounts are treated as deductible payments received from foreign related persons.
Under current law, because the United States treats the reverse hybrid as a corporation, the reverse hybrid’s income is generally not subject to current U.S. tax. Even if the reverse hybrid is treated as a CFC, its interest and royalty income from certain foreign related persons (which otherwise would qualify as subpart F income) may escape current U.S. taxation as a result of the exceptions under either Section 954(c)(3) or Section 954(c)(6). The payments to the reverse hybrid are also generally not subject to tax in the foreign jurisdiction because the foreign jurisdiction views it as a fiscally transparent entity and therefore treats its income as derived by its owners, including its U.S. owners. As a result of this hybrid treatment, income earned by the reverse hybrid under current law generally would not be subject to tax currently in either the United States or the foreign jurisdiction.
Expand anti-inversion rules
The budget would limit the ability of domestic corporations to expatriate by broadening the definition of an “inversion” under the anti-inversion rules of Section 7874. Specifically, the proposal would broaden the definition of an inversion transaction by reducing the 80% test to a greater-than-50% test and eliminating the 60% test. The proposal would also add a special rule whereby, regardless of the level of shareholder continuity, an inversion transaction occurs if the affiliated group that includes the foreign corporation has substantial business activities in the United States, and the foreign corporation is primarily managed and controlled in the United States. Finally, the proposal would amend Section 7874 to provide that an inversion transaction can occur if there is an acquisition of either substantially all of the assets of a domestic partnership (regardless of whether such assets constitute a trade or business) or substantially all of the assets of a trade or business of a domestic partnership.
The budget would allow for greater information exchange with foreign jurisdictions regarding financial account information of foreign nationals in the United States. FATCA, passed in 2010, requires foreign financial institutions to report information on U.S. account holders to the IRS to avoid a withholding tax. Foreign law often prevents foreign financial institutions from complying with the FATCA reporting provisions, but these legal impediments can be addressed through intergovernmental agreements. The proposal is meant to facilitate agreements by enabling the IRS to provide equivalent levels of information to cooperative foreign governments.
Ultimately, the proposal would require certain financial institutions to report the account balance for all financial accounts maintained at a U.S. office and held by foreign persons. The proposal would also expand the current reporting required regarding U.S. source income paid to accounts held by foreign persons to include similar non-U.S. source payments. Finally, Treasury would be authorized to issue regulations requiring financial institutions to report the gross proceeds from sales or redemptions of property in a financial account, information related to financial accounts held by certain passive entities with substantial foreign owners and other information Treasury determines is necessary.
Interest deductions for members of financial reporting groups
The budget would replace last year’s proposal aimed at the earnings stripping of expatriated entities with a broader version that would limit interest deductions for certain members of group that files a consolidated financial statement. Specifically, interest expense deductions would be limited to the member’s interest income plus the member’s proportionate share of the group’s net interest expense computed under U.S. income tax principles.
If a member fails to substantiate its proportionate share or makes an election, the interest deduction would be limited to 10% of the member’s adjusted taxable income, as defined under Section 163(j). Under either approach, disallowed interest would be carried forward indefinitely, and any excess limitation for a tax year would be carried forward three years. A member subject to the proposal would be exempt from Section 163(j).
The proposal would not apply to financial services entities, and those entities would not be included in the consolidated group for purposes of applying the proposal to other members of the group. The proposal would also not apply to consolidated groups that would otherwise report less than $5 million in net interest expense in the aggregate in a given year.
The administration’s proposal also makes a number of changes in the functioning of the federal tax system functions, including proposals that would:
- Give the IRS more flexibility to address correctable error
- Impose civil penalties for tax identity theft cases
- Increase penalties for paid tax preparers who engage in willful or reckless conduct
- Increase information sharing to administer excise taxes
Regulation of return preparers
The budget would explicitly provide the IRS and Treasury with the authority to regulate all paid tax return preparers — something also proposed in a discussion draft from Baucus. The proposal stems from litigation in the federal courts, where an appeals court recently held that the IRS and Treasury do not have the authority to regulate the paid return preparers.
The budget would adjust the tax return due dates for passthrough entities and corporations. Under current law, corporations, including subchapter S corporations, must file their annual income tax returns by the 15th day of the third month following the end of the tax year. Partnerships are required to file Form 1065 and furnish a copy of Schedule K-1 to partners by the 15th day of the fourth month following the end of the tax year.
The proposal would require passthroughs to follow the same 15th day of the third month deadline as S corporations, and give subchapter C corporations an additional month — to the 15th day of the fourth month following the end of the tax year — to file annual returns. A similar provision was included in the tax reform discussion drafts issued by both Camp and Baucus.
Like the budgets of his predecessors, President Obama’s budget reflects the aspirational goals of his administration. Several provisions retain bipartisan support, but it is unlikely the budget as a whole will be adopted by the politically fractured Congress.
It is notable that this fiscal year 2015 budget does not specifically address tax extenders, which expired at the end of 2013. Congress has routinely renewed these provisions, often retroactively. The Senate Finance Committee is expected to take up the matter of tax extenders in the next several weeks, but it is unclear when the House Ways and Means Committee will do the same, because its chair, Dave Camp, has focused on comprehensive tax reform in the short term.
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