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Camp proposes to rewrite tax code with 25% top corporate rate

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US Capitol BuildingHouse Ways and Means Chair Dave Camp, R-Mich., unveiled a full tax reform bill on Feb. 26 that would lower the top corporate and individual tax rates to 25%, with a 10% surtax on a broad category of income exceeding $400,000 for singles and $450,000 for joint filers. The bill was characterized as a discussion draft, but includes full legislative language and official revenue scores. Camp has not scheduled a committee markup, and the prospects for tax reform in 2014 still appear dim.

At its heart, the bill would repeal, limit or modify scores of existing tax provisions and use the revenue to cut rates. The top corporate rate would be cut from 35% to 25%. The top marginal rate on individual income would be cut from 39.6% to 25%, but a 10% surtax and a phaseout of many tax benefits at high income levels would result in a much higher top effective rate. The surtax includes an exception for income from domestic manufacturing, but it would apply to many kinds of income not currently subject to tax, including the value of employer-provided health coverage, the self-employment deduction for health coverage, tax-exempt interest and 401(k) contributions. Capital gains and dividends would be taxed as ordinary income with a 40% exclusion, resulting in a top effective rate of 21% with the surtax (not including the 3.8% net investment income tax (NII).

The bill would also move toward a more territorial tax system, with a 95% dividend exemption of foreign earnings and a new subpart F rule meant to tax intangible foreign income at 15%. It would also repeal both the corporate and the individual alternative minimum tax. Significant revenue-raising provisions in the draft would:

  • Create a new excise tax on financial institutions with at least $500 billion in assets
  • Repeal the modified accelerated cost recovery system (MACRS) and lengthen depreciable lives, while indexing depreciable basis to inflation
  • Limit the cash method of accounting
  • Repeal the LIFO and LCM  methods of accounting
    Tax a portion of carried interest of investment partnership as ordinary income
  • Eliminate the deduction for state and local taxes
  • Reduce the cap on mortgage interest deduction to $500,000 of debt

The legislation does not include any major changes to current gift and estate tax rules, and would not repeal the new 3.8% tax on NII under Section 1411. It would, however, repeal the medical device excise tax. It would also reform various rules for passthrough entities and slow inflation adjustments for the tax brackets.

The provisions are generally proposed to be effective prospectively after 2014, though there are transition rules and phase-ins in several areas. The following discusses the tax reform outlook and major provisions in more detail.

Outlook
The proposal is unlikely to gain much traction in this divided Congress. Camp himself has yet to schedule a markup of the bill and still faces skeptics in his own party. His counterpart in the Senate, the recently appointed Finance Committee chair Ron Wyden, D-Ore., has expressed a desire to address extenders more than comprehensive tax reform in the short term.
Republican leadership is also skeptical about Congress’ ability to pass a tax reform bill in 2014. Senate Minority Leader Mitch McConnell, R-Ky., said recently that he has “no hope” that a divided Congress could pass tax reform this year. The president has offered only tepid support for tax reform. On the same day Camp released his bill, the administration again proposed using up to $150 billion in revenue from pro-growth tax reform to pay for infrastructure spending. President Obama’s budget is due March 4 and will likely include tax proposals similar to past years.

The main issue between the two parties continues to be revenue. Democrats have insisted that tax reform raise revenue, while Republicans have insisted on revenue neutrality. The Joint Committee on Taxation (JCT) estimated that Camp’s discussion draft would be nearly revenue neutral (raising a net of $3 billion over 10 years) compared to current law. But the JCT also estimated that the macroeconomic effects of the bill could increase GDP and employment up to 1.5%, and that the economic growth would result in additional revenue of $50 billion–$700 billion.

Individuals
The proposed change would generally replace the seven current tax brackets with just two brackets of 10% and 25% (see table), plus a 10% surtax that would apply to a broad category of income and deductions once adjusted gross income (AGI) exceeded the current top bracket ($406,750 for singles and $457,600 for joint filers in 2014). The brackets would then be indexed to an alternative consumer price standard that would lead to shallower inflation adjustments.

Proposed changes in individual tax rates

Income brackets (2014)

Rates

Single

Joint

Current

Proposed

$0+

$0+

10%

10%

$9,075+

$18,150+

15%

$36,900+

$73,800+

25%

25%*

$89,350+

$148,850+

28%

$186,350+

$226,850+

33%

$405,101+

$405,101+

35%

$406,750+

$457,600+

39.6%

25% + 10% surtax**

Top dividend and cap gains rate

20%

21% effective rate***

*The starting point for the 25% bracket would be reduced slightly.
**The surtax would apply to certain income beyond taxable income.
***Capital gains and dividends are ordinary income with 40% exclusion. Does not include 3.8% tax on NII.

The 10% surtax would apply to more than traditional AGI. It would also capture tax- exempt interest, the standard deduction, all itemized deductions except for charitable contributions, the foreign earned income exclusion, contributions to 401(k)s and other qualified plans, the value of employer-provided health coverage, the self-employment deduction for health premiums, contributions to health savings accounts, and any Social Security benefits excluded from income. It would not include income from qualified domestic manufacturing. Capital gains and dividends would be taxed at ordinary income tax rates with a 40% exclusion, with a top effective rate of 24.8% after the surtax and the 3.8% tax on NII.

The discussion draft would repeal the individual AMT but includes other phaseouts that would increase the effective rate on high-income taxpayers, including proposals to:

  • Phase out the benefit of the 10% bracket beginning at AGI of $250,000 for singles and $300,000 for joint filers
  • Phase out the standard deduction beginning at modified AGI of $358,750 for singles and $517,500 for joint filers
  • Phase out the child credit beginning at modified AGI of $413,750 for singles and $627,500 for joint filers 

The discussion draft would increase the standard deduction from $6,100 to $11,000 for singles, and from 12,200 to $22,000 for joint filers. No personal exemptions would be provided, but an additional standard deduction of $5,500 would be available for taxpayers with a qualifying child. The discussion draft would also limit or repeal scores of individual tax benefits, including:

  • Repealing the state and local tax deduction
  • Repealing the deduction for medical expenses
  • Gradually reducing the cap on the mortgage interest deduction for new mortgages from $1 million in debt to $500,000 in debt
  • Limiting charitable contributions to excess of 2% of AGI

The remaining credits would generally be consolidated and simplified. The child tax credit would increase from $1,000 to $1,500. The earned income tax credit would be replaced with a refundable credit for employment taxes. The various deductions and credits for education would be replaced with a $2,500 credit similar to the current American Opportunity Tax Credit.

C corporations
The discussion draft would gradually reduce the top corporate rate from 35% to 25% from 2015 through 2019 (see table). The corporate rate brackets would be collapsed so that all corporate income would be subject to the 25% rate and the corporate alternative minimum tax would be repealed.

Proposed changes in corporate tax rates 

Income

Current

Proposed

$0 +

15%

25%

$50,000+

25%

$75,000+

34%

$100,000+

39%

$335,000+

34%

$10 million+

35%

$15 million+

38%

$18.3 million+

35%

Passthrough entities
Rates
The restructuring of corporate and individual tax rates in the discussion draft would mean that S corporation and partnership earnings would likely be subject to a higher current tax rate than equivalent earnings in a C corporation. When fully phased in, the corporate rates would be 25%, while the top individual rate would be 35%. A special proposal allows qualified domestic manufacturing income earned through a partnership or S corporation to be taxed at the same current rate as income in a C corporation, but that equivalency is not extended to income from services, retail or other sources that do not meet the definition of domestic manufacturing.

Self-employment income
The discussion draft would significantly modify the employment tax treatment of a partner or an S corporation shareholder who materially participates in a trade or business.   These partners and shareholders would treat 70% of any compensation and distributable income as self-employment income, and the remaining 30% as earnings on invested capital not subject to self-employment tax. The 3.8% Medicare tax on NII is not affected by the proposal, so partners and S corporation shareholders who materially participate would not be subject to any additional employment tax on the 30% of earnings considered to be from invested capital. Partners and S corporation shareholders who do not materially participate would not be required to pay self-employment taxes, but would still be subject to the 3.8% tax on NII tax.

The rules exempting limited partners and S corporation shareholders from self-employment tax on their distributable income would be repealed. Unit holders in an LLC taxed as a partnership would be subject to the same rules as partners, with their liability for self-employment tax based on their material participation (or lack thereof) in the trade or business of the LLC.

Partnerships
The discussion draft proposes several changes designed to limit the use of partnerships as tax avoidance vehicles, including proposals that would:

  • Eliminate the concept of guaranteed payments
  • Make mandatory adjustments to the basis of partnership property in cases of transfers of partnership interests
  • Require distributions of inventory items to be treated as a sale from the partnership to the partner
    Eliminate technical terminations, allowing a partnership to continue in existence when more than 50% of capital or profits interests are sold or exchanged
  • Require publicly traded partnerships to be taxed as C corporations unless 90% of income relates to mining and natural resources

S corporations
The Camp discussion draft includes a number of proposals intended to expand the availability of S corporation status by providing greater flexibility in organization and operation, addressing specific complexities, and providing greater opportunity to recover from unintended errors. Noteworthy changes that will expand the availability of S corporation status include:

  • Permanent reduction of the built-in gain recognition period from 10 to five years
  • Increase in the amount of passive income allowed an S corporation before the passive income tax is triggered from 25% to 60%
  • Expansion of the list of qualified shareholders to include nonresident aliens who own their shares through an electing small business trust (ESBT)
  • Allowance of S corporation elections to be made on a timely filed tax return for the year the election is effective

Credits and incentives
The discussion draft repeals almost all of the general business credits, including commonly used credits such as the work opportunity tax credit, the empowerment zone employment credit and the employer provided child care credit. The Section 199 deduction for domestic production activities would be repealed, but the research credit would be amended and made permanent.

Beginning in 2014 the research credit would be determined using the alternative simplified credit methodology with a 15% rate. Accordingly, the credit would equal 15% of the excess of qualified research expenses for the year over 50% of the average research expenses for the preceding three years. Qualified research expenses would no longer include the cost of supplies and computer software. The discussion draft would also repeal the special rules allowing 75% of amounts paid to a qualified research consortium and 100% of amounts paid to small businesses, universities and federal laboratories to be considered qualified research expenses.

The discussion draft includes a number of proposals that would affect natural resource activities, including:

  • Repeal of percentage depletion, including percentage depletion on existing mines and wells
  • Repeal of the passive activity exception for working oil and gas interests

The discussion draft would also eliminate a wide range of alternative energy and conservation incentives, including special deductions and credits for:

  • Generating electricity from unconventional sources such as solar and wind
  • Producing biofuels
  • Using energy-efficient products and construction by individuals and businesses
  • Acquiring alternative fuel vehicles.

Cost recovery
The discussion draft would raise significant revenue for rate cuts by lengthening cost recovery. Unlike the “pooling” method outlined in the discussion draft for former Senate Finance Committee Chair Max Baucus, D-Mont., the approach in Camp’s bill would raise $270 billion by repealing the modified accelerated cost recovery system (MACRS) and applying rules substantially similar to the alternative depreciation system (ADS) to depreciable property. Taxpayers could elect to take an additional depreciation deduction to account for the effects of inflation, and the bill would require Treasury to re-examine the class lives of depreciable assets and issue revised guidance.

The discussion draft would also raise revenue from several other proposals to slow cost recovery or disallow deferral, including provisions that would:

  • Require research and experimentation expenditures to be amortized over a five-year period beginning with the midpoint of the tax year in which the expenditure is paid or incurred (phased in slowly beginning in 2015)
  • Allow only 50% of advertising expenses to be deducted immediately with 50% amortized ratably over a 10-year period
  • Increase the recovery period of goodwill and intangibles from 15 to 20 years
  • Repeal like-kind exchanges

The bill would also cap Section 179 expenses at $250,000 per year, with the deduction being phased out for investments exceeding $800,000. That cap would reflect an expensing limitation made permanent at the 2008 to 2009 levels.

Accounting methods
The discussion draft raises additional revenue by restricting the cash method of accounting and repealing the last in, first out (LIFO) and lower or cost or market (LCM) methods of accounting.

Under the legislation, the cash method would be available only to businesses with average annual gross receipts of $10 million or less, farming businesses and sole proprietors. The proposal would raise $23.6 billion over 10 years and could be reintroduced in the future as a revenue raise on other legislation if the discussion draft does not advance.

The discussion draft would provide transition relief for all three accounting method changes. The LIFO and LCM reserves and the adjustment from cash to accrual would not be included in income until the first tax year beginning after 2018, when 10% would be included in income, followed by 15%, 25% and 50% in the succeeding years (a taxpayer could elect earlier inclusion). In addition, under a  special rule, closely held companies (generally those with 100 or fewer shareholders) no longer allowed to use LIFO could exclude 80% of their LIFO reserve (72% in the case of a C corporation), resulting in an effective tax rate of 7% on those amounts.

International
Territorial shift
The discussion draft would generally move toward a territorial tax system with a 95% exemption for dividends from a foreign corporation to a U.S. corporate shareholder that owns at least 10% of the foreign corporation. No foreign tax credit or deduction would be allowed for foreign income and withholding taxes with respect to any exempt dividend, and the U.S. parent would reduce the basis of stock in a foreign subsidiary by the amount of any exempt dividends. The basis reductions would apply only for determining the amount of a loss, but not gain, from the sale of the foreign subsidiary stock. If a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the U.S. corporation would include in income the amount of any post-2014 losses previously incurred by the branch to the extent the U.S. corporation receives exempt dividends from any foreign subsidiaries.

A transition rule would require U.S. shareholders owning 10% or more of a foreign subsidiary to include in income at reduced rates all post-1986 earnings and profits (E&P) that have not yet been subject to U.S. tax. The tax liability would be payable over eight years, 8% in the first five, then 15%, 20% and 25% in the following three years. The E&P would be divided into cash, cash equivalents and certain other short-term assets, versus E&P that has been reinvested in the foreign subsidiary’s business (property, plant and equipment). The cash or cash equivalents would be taxed at 8.75%, while any remaining E&P would be taxed at 3.5%. Foreign tax credits would be partially available to offset the U.S. tax. For an S corporation U.S. shareholder, the provision applies when the S corporation ceases to be an S corporation, substantially all of the assets of the S corporation are sold or liquidated, the S corporation ceases to exist or conduct business, or stock in the S corporation is transferred.

Foreign tax credits
A foreign tax credit would be allowed only for any subpart F income included in the income of the U.S. shareholder on a current year basis, without regard to pools of foreign earnings kept abroad. Only expenses directly attributable to income earned by a foreign subsidiary would be allocated against foreign-source income for purposes of calculating the U.S. parent’s foreign-source income and the amount of 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. 

Foreign tax credits would be put into to two baskets: mobile and active. The mobile basket would include certain related-party sales income, foreign intangible income and current-law passive income. The active basket would include all other income. Income from the sale of inventory produced in and sold outside the United States (or vice versa) 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.

Subpart F
The discussion draft would maintain and modify Subpart F. The 90% threshold for treating foreign income as subpart F income would increase to 100% (25% for C corporations) for foreign personal holding company income. For foreign base company sales income (FBCSI), the threshold would generally be cut to 50% of the U.S. rate (for an effective rate of 12.5% for C corporations). The threshold for foreign base company intangible income would be 60% of the U.S. rate (for an effective rate of 15%). This treatment would no longer be elective. FBCSI would no longer include 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% or greater.

The $1 million de minimis threshold for foreign-based company income would be adjusted for inflation, and the active financing exception would be extended with limits for low-taxed foreign income. The exception would be extended for five years for active financing income that is subject to a foreign effective tax rate of 12.5% or higher. Active financing income that is subject to a lower foreign tax rate would not be exempt, but would be subject to a reduced U.S. tax rate of 12.5% before foreign tax credits were applied.

The draft would also repeal the imposition of current U.S. tax on previously excluded foreign shipping income of a foreign subsidiary if there is a net decrease in qualified shipping investments. 

Base erosion proposals
The discussion draft would create new base erosion provisions that would subject a U.S. parent of a foreign subsidiary to U.S. tax on a new category of subpart F income, “foreign base company intangible income” (FBCII). FBCII would equal the excess of the foreign subsidiary’s gross income over 10% of the foreign subsidiary’s adjusted basis in depreciable tangible property (with exceptions for commodities). The U.S. parent could claim a deduction equal to a percentage of the foreign subsidiary’s FBCII that relates to property that is sold for use, consumption or disposition outside the United States or to services provided outside the United States. The deduction would also be available to U.S. corporations that earn foreign intangible income directly (rather than through a foreign subsidiary). The deductible percentage of FBCII and foreign intangible income would be 55% for tax years beginning in 2015, 52% in 2016, 48% in 2017, 44% in 2018 and 40% for tax years beginning in 2019 or later.

Deductible net interest expense of a U.S. parent of one or more foreign subsidiaries would be reduced by the lesser of the extent to which (1) the indebtedness of the U.S. parent (including other members of the U.S. consolidated group) exceeds 110% of the combined indebtedness of the worldwide affiliated group (including both related domestic and related foreign entities), or (2) net interest expense exceeds 40% of the adjusted taxable income of the U.S. parent.

Financial industry
The discussion draft would significantly change financial industry tax rules, including a new excise tax on large financial institutions, new rules for marking to market derivatives, and taxing carried interest as ordinary income.

The new excise tax would impose a quarterly 0.035% levy on the total consolidated assets exceeding $500 billion of systemically important financial institutions (SIFIs). After 2015, the $500 billion threshold would be indexed for increases in the gross domestic product. The proposal differs from the bank tax proposed by President Obama, which would impose a 17 basis point “financial crisis responsibility fee” on certain banks’ covered liabilities.

The discussion draft would also require mark to market treatment for derivatives, with gains or losses being treated as ordinary income or loss. Transactions that are properly identified as hedging transactions would not be required to be marked to market. Under a separate proposal in the bill, taxpayers needing to identify a hedge for tax purposes could rely on their identification of a hedge for financial accounting purposes

Finally, the bill would recharacterize the carried interest income from a partnership in the trade or business raising or returning capital; identifying, investing in or disposing of other trades or businesses; and developing such trades or business. The bill would generally limit the amount of carried interest that a service partner could claim as capital gain based on a formula and recharacterize the rest as ordinary income.

Compensation and benefits
Executive compensation
The discussion draft would significantly change nonqualified deferred compensation plans. Currently, employees are generally required to recognize this compensation income in the year a distribution is made to the employees, regardless of when the deferred compensation became vested, unless they are employees of a tax-exempt organization (in which they recognize income when vested). The proposal would tax all compensation in the year it becomes vested, unless the compensation is paid to the employees within six months following the end of the taxable year in which it becomes vested. The current-law rules would continue to apply to existing nonqualified deferred compensation arrangements until the last tax year beginning before 2023. 

In addition, the bill would expand the Section 162(m) limits on a public company’s ability to deduct compensation. Currently employers can only deduct up to $1 million in compensation of any “covered employee,” with an exception for commissions and qualified performance-based compensation. The discussion draft would repeal the exclusion for performance-based compensation and commissions, and expand the definition of covered employee to include the CFO. Also the $1 million deduction limit would apply for a “covered employee” as long as the corporation pays remuneration to that person (or to any beneficiaries), even if the person is no longer serving in the roles of a covered employee.

Retirement plans
The discussion draft would significantly change both individual retirement account and qualified plan rules. The legislation would prohibit future contributions to traditional individual retirement accounts (IRAs), but remove the income limitations on contributing to Roth IRAs. Contributions to a traditional IRA are generally deductible, while contributions to a Roth IRA are not. Distributions from a traditional IRA are generally included in income, while qualifying distributions from a Roth IRA are not. The change would not affect current balances included in traditional IRAs or the way the current balances are taxed when distributed.  

The discussion draft would also allow employees to direct only half of their allowable contributions to qualified plans like 401(k)s, 403(b)s, and governmental 457(b)s to traditional accounts, and the remaining amount could be made only to a Roth account. The maximum annual elective deferral amount is currently $17,500, meaning an employee without catch-up contributions would be able to contribute only up to $8,750 to a traditional 401(k) plan account. The provision would apply only to employers with 100 or more employees. 

In addition, employers would not be permitted to establish new Simplified Employee Pension (SEP) IRAs or Savings Incentive Match Plans for Employees (SIMPLE) 401(k) plans after 2014. Employers would be permitted to continue contributing to existing SEPs and SIMPLE 401(k) plans and establish new SIMPLE IRAs. 

Severance pay
The discussion draft would provide that all severance payments, including supplemental unemployment benefits, would be subject to Medicare and social security tax. The provision appears to be a response to the Supreme Court case U.S. v. Quality Stores, Inc., in which the Court is currently considering whether supplemental unemployment benefits are excludible from wages subject to Medicare and social security tax.

Worker classification
The discussion draft would establish a safe harbor that would apply for purposes of determining whether a worker is an employee or an independent contractor. Under current law, the determination of whether a worker is an employee or an independent contractor is generally made under a common-law facts-and-circumstances test. Workers qualifying for the safe harbor would not be treated as employees, and the service recipient would not be treated as the employer for any federal tax purpose. To qualify for the safe harbor, the worker would have to satisfy certain sales or service criteria, and the worker and service recipient would be required to have a written agreement that meets specified requirements.  In addition, the service recipient would withhold tax on the first $10,000 of payments made to the worker in a year at a rate of 5%. In any case in which the IRS determines that the requirements of the safe harbor were not satisfied, the IRS would be limited to reclassifying the worker on a prospective basis. 

Tax administration
The discussion draft includes provisions aimed at simplifying rules and easing tax administration, including many of the provisions in the tax administration discussion draft from former Senate Finance Committee Chair Max Baucus.

The draft would modify the schedule for filing tax returns by certain entities. Partnerships and subchapter S corporations would be required to file their tax returns by March 15 (or two and a half months after the close of their tax year), and C corporations would have to file by April 15 (or three and a half months after the close of their tax year). C corporations would also be given an automatic six-month extension of the applicable filing date.

The bill would also increase penalties for taxpayers who fail to timely file a tax return, information return or payee statement.

The discussion draft also includes a provision that would apply a six-year statute of limitation to a return on which a taxpayer claims an adjusted basis for any property that is more than 125% of the correct adjusted basis. The proposal is a legislative response to the Supreme Court’s 2012 decision in Home Concrete & Supply LLC v. United States (132 S. Ct. 1836), in which the Court ruled that overstated basis does not constitute an omission from gross income that triggers the six-year statute of limitations period.

Finally, the draft would repeal the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and electing large partnership (ELP) audit rules. In their place, partnership audit rules would be streamlined into a single set of rules for auditing partners at the partnership level. Partnerships with fewer than 100 partners would be able to opt out of the new audit rules.

Contact
Mel Schwarz
202.521.1564
mel.schwarz.@us.gt.com

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