Senate Republicans pushed through their tax reform bill on a 51- 49 vote after making significant changes to the legislation to secure the narrow margin of victory. The changes to the bill deepen the divide between the House and Senate versions in several key areas, but a resolution appears within reach.
The next step will be to reconcile the two bills. Senate leaders are pressuring the House to simply vote on the Senate bill, but House leaders are not expected to capitulate. House Speaker Paul Ryan, R-Wis., promised his members that the House and Senate would convene an official conference committee. A conference committee would be tasked with forging a compromise version that would need to pass both chambers again.
Senate Republicans’ narrow majority should give them considerable leverage in negotiations on a final version. Senate Republicans lost the vote of retiring Sen. Bob Corker, R-Tenn., and can lose just one more and still have the 50 votes needed to pass a conference report. House Republicans enjoy a larger 240- 194 majority and passed their tax reform bill in a more comfortable 227- 205 vote. Still, the House could push the Senate for concessions in some key areas, particularly the effective date of the corporate rate cut.
The last-minute changes made by the Senate adopt House provisions in some areas, such as the state and local tax deduction, but also make changes likely to be unpopular with House members, such as retaining the alternative minimum tax (AMT). Major changes made on the Senate floor include:
- Retaining the individual AMT with a 39% increase in the individual AMT exemptions
- Retaining the corporate AMT, with severe and perhaps unintended consequences for credits and the dividends received deduction
- Increasing the deduction for pass-through business income from 17.4% to 23% and allowing certain publicly traded partnerships (PTPs) and real estate investment trusts (REITs) to qualify
- Accelerating the effective date of the repeal of Section 199 for pass-throughs to tax years beginning after Dec. 31, 2017
- Extending bonus depreciation for five additional years at rate of 80% for property placed in service in 2023, 60% for 2024, 40% for 2025 and 20% for 2026
- Preserving the state and local tax deduction for up to $10,000 in property taxes
- Increasing the rates for the one-time tax on unrepatriated earnings to 14.49% for cash and cash equivalents and 7.49% for other assets
- Phasing in the limit on global interest limitation with more favorable rates for the debt equity differential used in the limitation calculation
- Preserving the Interest Charge Domestic International Sales Corporation (IC-DISC) regime that was repealed under earlier versions
- Exempting mortgage servicing rights from new income recognition book matching rules
- Lowering the adjusted gross threshold for the itemized deduction for medical expenses from 10% to 7.5% for 2017 and 2018
- Removing a provision requiring income related to names and logo to be included in unrelated business income (UBIT)
- Doubling the threshold for the application of to 1.4% tax on university endowments from total assets exceeding $250,000 per student to total assets exceeding $500,000 per student
Republicans are expected to vote to go to conference very soon and are pushing to have a bill enacted before Christmas. Although there are major unresolved differences in the two bills, the differences do not appear insurmountable. Hurdles remain, but it is possible, and maybe even likely, that a sweeping, transformative tax reform bill is enacted in the next several weeks. The changes would create both immediate and long-term tax planning challenges and opportunities.
The following provides more details on the key provisions in the House and Senate bills, the differences and similarities, and important considerations.
Revenue impact and ‘sunrise’ and ‘sunset’ provisions
The biggest difference between the two bills is the long-term revenue impact. The House bill violates reconciliation restrictions that preclude revenue loss outside the 10-year budget window. The Senate bill complies with this restriction with both “sunset” and “sunrise” provisions. Under the Senate bill, all individual provisions, with two exceptions, would expire Dec. 31, 2025. The two exceptions are the repeal of the excise taxes for individuals who do not obtain health coverage (usually called the “individual mandate”) and the use of a slower inflation adjustment for the individual tax brackets. The retention of these two revenue-raising provisions means the bill is estimated to permanently increase individual taxes beginning in 2026. Republicans have pledged they will later extend many of the individual tax cuts.
The Senate bill also includes “sunrise” revenue-raising provisions that would not take effect until much later in order to raise revenue outside of the budget window. Among them are provisions to increase the limit on NOL deductions, require R&D expenses to be amortized over five years, repeal the deduction for meals provided for the convenience of the employer and increase rates and lower deductions for the international base-erosion rules. Republicans hope to repeal these revenue increases before they take effect.
The House will likely be forced to accept many of these sunset and sunrise provisions or find alternative ways to raise substantial revenue. Although repealing the individual mandate was expected to be controversial, it did not cost any Senate Republican votes. Sen. Susan Collins, R-Maine, expressed reservations about it, but ultimately supported the bill after receiving assurances that her health care concerns could be addressed in another bill. The provision is likely to be popular with conservatives in the House, though a handful of moderates could oppose it.
Deficit concerns could be a threat. The reconciliation instructions allow up to $1.5 trillion in revenue loss within the 10-year budget window. The House-passed bill is estimated to cost $1.437 trillion over the next 10 years, while the Senate-passed bill is estimated to cost $1.448 trillion. The Joint Committee on Taxation provided a macroeconomic analysis of the Senate bill that estimated it would increase the economy by about 0.8% over the next 10 years, creating more than $400 billion in additional revenue. Although this is a substantial sum, it falls short of assertions Republicans made that economic growth would pay for the entire cost of the bill.
Republicans immediately attacked the estimate as incomplete and not reflective of the final bill (it was conducted on an earlier version). More importantly, deficit concerns only cost Senate Republicans the vote of Corker. Other senators raised similar concerns but ultimately supported the bill. Some conservative House members could raise deficit objections, but it is unclear whether it would be enough to force any changes.
Grant Thornton Insight: The sunset and sunrise provisions raise questions about how permanent any enacted tax reform bill may be. There will be opportunities to address sunrise and sunset provisions before they expire or take effect, but this can be politically difficult. In addition, Democrats are attacking the legislation aggressively and should be expected to run on promises to amend or reverse certain aspects of it. Although tax reform is intended to spur investment and economic growth with a permanent shift in the structure of international and domestic business taxation, business planning may continue to be difficult in an uncertain political and tax policy environment.
The House and Senate bills both provide substantial individual rate cuts, but in very different ways. The House leaves the top rates on ordinary income intact, and instead achieves rate cuts by condensing the seven current tax brackets into four. Although the thresholds do not match precisely, the changes loosely correspond to combining the 10% and 15% brackets into a 12% bracket, combining the 25% and 28% brackets into a 25% bracket, and combining the 33% and 35% brackets into a 35% bracket. The 39.6% bracket begins at a higher income level under the bill, but the House includes a 6% surtax once income reaches $1 million (single) or $1.2 million (joint) until the benefit of the 12% bracket is erased.
The Senate preserves current seven tax brackets and instead lowers the rates for many of them:
- 10% retained
- 15% lowered to 12%
- 25% lowered to 22%
- 28% lowered to 25%
- 33% lowered to 32%
- 35% retained
- 39.6% lowered to 38.5%
The Senate bill also adjusts the thresholds for many of the tax brackets, including pushing the top bracket much higher. The Senate does not include the House bill’s 6% surtax on high-income taxpayers. Both bills leave the top tax rate on capital gains and dividends unchanged at 20%, but the House bill expands the amount of capital gains and dividends that qualify for the zero and 15% capital gains tax brackets. Both bills would permanently change the calculation of inflation used to adjust all the tax brackets, causing shallower adjustments.
Both bills would also make many other significant changes to individual tax deductions, credits, and incentives. See the tables below for some of the more significant changes. As stated earlier, all individual provisions except for the repeal of the individual mandate and the tax bracket inflation adjustments would be set to expire in 2026 under the Senate bill.
Grant Thornton Insight: The Senate’s individual rates cuts are more generous than in the House, costing $1.17 trillion compared to $1.09 trillion. The lower rates in the Senate bill also means that version raises $341 billion less by repealing personal exemptions. This revenue difference is one of the reasons the Senate was forced to make several painful choices on the Senate floor, such as retaining the AMT. A move toward the shallower rate cuts in the House version could free up revenue to provide relief for some of the more unpopular revenue-raisers in both bills.
Basis for securities sales
The Senate bill includes a provision not in the House bill that severely limits the ability of taxpayers to control their gain or loss on the sale of securities. Under current law, taxpayers selling securities from a pool of identical stock acquired at different prices may specifically identify which shares they are selling for determining the basis used to compute gain or loss. Under the Senate bill, taxpayers would be required to use a “first-in, first-out” method for securities sales on or after Jan. 1, 2018, and before Jan. 1, 2026. A special exception is available for regulated investment companies, which would still be able to elect the averaging method.
Grant Thornton insight: This provision will be important for any taxpayer who holds securities with different bases, and particularly for taxpayers receiving stock awards or options. For example, the immediate sale of stock options after exercising could produce a very different result than under current law if the taxpayer owns other shares. Taxpayers may consider accelerating sales or exercising options before the effective date to manage gain and loss.
The House bill would repeal the individual AMT for tax years beginning in 2018. Taxpayers with unused AMT credits could claim up to 50% of the credits as refundable in each of 2019, 2020, and 2021, with all remaining credits claimed in 2022.
The Senate made a last-minute change retaining the individual AMT, but increasing the exemption amounts by 39% through 2025. The exemption amounts would continue to be indexed for inflation.
Both the House and Senate bills would double the lifetime gift, estate and generations-skipping transfer (GST) tax exemptions from $5.6 million (2018 figure after inflation adjustments) to $11.2 million, and continue to index them for inflation. The House bill would then repeal the estate and GST taxes beginning in 2024, but retain the gift tax after lowering the rate from 30% to 35%. The House bill would retain the step up in basis on inherited assets. The Senate bill would not repeal the taxes, and the increase in the exemptions would expire in 2026.
The House and Senate bills would both replace the current corporate rate schedule with a flat rate of 20%, but the House bill would be effective for tax years beginning after Dec. 31, 2017, while the Senate bill would be effective for tax years beginning after Dec. 31, 2018. Under both versions, fiscal year taxpayers would use a blended rate depending on how much of their tax year came before or after the Dec. 31 effective dates.
Both bills would reduce the dividend-received-deduction (DRD) rates. The 70% DRD would be reduced to 50%, while the 80% DRD would be reduced to 65%. The changes are meant to compensate for the reduced corporate tax rate of 20%. The House bill would also reduce the 35% flat rate for personal service corporations to 25%.
Pass-through business rate
The two bills use very different structures to provide an effective rate cut for pass-through businesses such as partnerships, S corporations and sole proprietorships. The House bill provides a 25% rate on qualifying business income. Owners considered passive under the rules in Section 469 would generally qualify for the 25% rate on all their income from the entity. Active owners would receive the 25% rate only on the portion of their income considered a return on investment, with the rest treated as compensation and taxed at ordinary income tax rates.
A safe harbor would allow active owners to treat 30% of their income as qualifying. It would not be available for professional service businesses, defined as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade of business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
Active owners could also elect to determine the amount of income eligible for the 25% rate using a return-on-capital calculation. The election to use this method is binding for five years. The calculation applies a deemed rate of return of 7% plus the short-term adjusted applicable federal interest rate (currently 1.27%) to the owner’s share of the adjusted basis in the depreciable property or other real property used in the business activity (minus deductible interest). Adjusted tax basis is determined without taking into account the bonus depreciation or Section 179 expensing.
Owners of the professional service businesses defined above could use this method only if the result of the calculation was equal to at least 10% of their total income from the entity. If the result falls under this threshold, no income from the entity would qualify for the 25% rate. Any dividend from a real estate investment trust not treated as a capital gain or a qualified dividend would be eligible for the 25% rate.
The Senate bill creates an entirely different regime, offering a 23% deduction for qualifying pass-through business income. The deduction is limited to 50% of W-2 wages paid by the owner. Wages are assigned to owners in the same proportion that wage expense is allocated. Taxpayers with up to $250,000 (single) or $500,000 (joint) in taxable income would not be subject to the wage restriction. The wage restriction would phase in from those thresholds over the next $50,000 (single) or $100,000 (joint) in taxable income.
Qualifying business income generally would not include capital gains, dividend, or interest. The deduction would not be affected by whether the owner is active or passive, but qualified business income would not include wages of an S corporation owner or guaranteed payments for services by partners. The Senate bill does not include any additional measures to distinguish compensation or service income from business income. The legislation would rely on the existing reasonable compensation standards for S corporation owners, but it should be noted there is no requirement that partners receive any guaranteed payment for services.
Income from certain service businesses would qualify for the deduction only for taxpayers with up to $250,000 (single) or $500,000 (joint) in taxable income. The deduction would phase out over the next $50,000 (single) or $100,000 (joint) in taxable income. The Senate bill uses the same definition of service businesses as the House, but specifically adds investing and investment management, trading, and dealing in securities, partnership interests or commodities.
The deduction is available for certain PTPs and REITs under a last-minute addition to the bill. It is not available for trusts and estates. The legislative language does not make clear whether the deduction would be available for trust income taxed only at the individual level, such as with grantor trusts and qualified subchapter S trusts.
Grant Thornton Insight: The two approaches create vastly different results for different kinds of taxpayers. If allowed in full, the Senate deduction would have the effect of reducing the rate on income subject to the 38.5% rate to 29.6%. That is considerably higher than the 25% rate offered by the House version for passive owners, but may be lower than the effective rate that would apply to many active owners under the House’s methods for calculating qualifying income. For service businesses, the Senate bill is much more generous if taxable income falls under the taxable income thresholds, but provides nothing above it. The House bill creates a high hurdle for service businesses, but it is not limited by income. The House version costs $597 billion over 10 years, compared to just $476 billion for the Senate bill. Administration officials have indicated they prefer the Senate version because they believe it is easier to administer. Although only the Senate includes a 2026 sunset, either version would likely be required to expire as part of a final bill in order to comply with reconciliation requirements.
Pass-through business provisions
The Senate bill raises $176 billion with a significant new revenue-raiser not in the House bill that would prevent pass-through owners from using a business loss against other kinds of income. Under current law, taxpayers with passive losses generally only deduct these losses against passive income, but non-passive owners can generally deduct business losses. The proposal would require pass-through owners to aggregate trade or business income and loss, and any net loss in excess of $250,000 (single) or $500,000 (joint) would not be deductible. Any net loss would instead be added to the net operating loss (NOL) carry-forward.
The House bill would repeal the current law provision that terminates a partnership if at least 50% of its capital and profits interest are sold or exchanged within 12 months. The Senate bill does not include this provision.
Grant Thornton Insight: After a technical termination, the partnership is treated as newly formed, even though it continues on in the same legal entity. Any previous accounting-method elections and Section 754 elections would no longer be valid, and depreciation would generally be restarted over a new recovery period by the newly formed partnership. This common trap can have severe tax consequences.
Both bills would require assets held by partnerships in certain investment-related trades or businesses to be held for at least three years in order for partners who receive their partnership interest in exchange for services to enjoy long-term capital gain treatment when the assets are sold.
Expansion of mandatory basis adjustments for built-in-losses
The Senate bill would modify the definition of a substantial built-in-loss in the context of transfers of partnership interests. Under current law, a substantial built-in-loss exists if the partnership’s adjusted basis in its property exceeds its fair market value by more than $250,000. The provision would expand that definition to include situations where a transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition of all the partnership’s assets immediately after purchasing a partnership interest.
Charitable contributions and foreign taxes limited by basis rules
The Senate bill would disallow a partner’s distributive share of charitable contributions and foreign taxes, accrued or paid, to the extent they exceed the partner’s basis in a partnership interest. Currently, the basis limitation rules on partnership losses do not take into account partnership charitable contributions or foreign taxes paid, in contrast to the basis limitation rules for S corporations.
Key business provisions
Cost recovery and interest limitation
Both bills include significant changes to cost recovery paired with new limits on the interest deduction. Moving toward full expensing was part of a push by House Republicans to move to a more cash-flow-based tax that mimics a consumptions tax. In the end, both bills only make a limited move in this direction. See the table below for details on the cost-recovery provisions and the limit on interest expense.
Corporate AMT and NOL
The House bill would repeal the corporate AMT effective for tax years beginning after Dec. 31, 2017. Taxpayers with unused AMT credits could claim 50% of the credits as refundable in each of the years 2019, 2020, and 2021, with all remaining credits claimed in 2022. However, the House bill would essentially import the AMT provision limiting NOL deductions to 90% of taxable income and apply it outside of the AMT. It would repeal NOL carry-backs but allow indefinite carry-forwards and index the value of the NOL to an inflation rate of 4% plus the short-term adjusted federal rate.
The Senate made a change at the last minute to retain the corporate AMT. Despite this change, the bill still imposes a 90% NOL limitation independently through 2022, after which NOLs are limited to 80% of taxable income. The Senate includes the same changes on carryforwards and carrybacks but exempts property and casualty insurance companies from the new regime. The NOLs of these companies would continue to use a two-year carry-back and a 20-year carry-forward without any taxable income limit.
Grant Thornton Insight: The retention of the corporate AMT creates startling and perhaps unintended result. Because the 20% AMT rate would be equal to the general 20% corporate rate, any company with an AMT preference would immediately pay AMT and the preference items would be disallowed. It appears the dividends received deduction would effectively be disallowed by the AMT. In addition, general business credits that are not allowed against the AMT would essentially be rendered moot. The R&D credit is retained by the bill but is effectively unusable under this AMT regime. It appears this result was not fully understood or intended, as the change was made quickly right before passage. The reinstatement of the corporate AMT saves only $40 billion and these issues are likely to be fixed in conference.
Both bill target many business credits and deductions in order to raise revenue to help pay for the rate cut. The table below provides details on many of the major changes.
The House and Senate bills include differing increases in the $5 million gross receipts eligibility threshold for several favorable accounting methods. The House bill sets a $25 million threshold while the Senate sets a $15 million threshold for the following methods:
- Cash method under Section 448 for corporations and partnerships with corporate partners (also no longer required to meet gross receipts testing for all prior years)
- Section 447 method of accounting for corporations engaged in farming
- Exceptions from the Section 263A uniform capitalization rules
- Special rules in Section 460 for long-term construction contracts (does not include long-term manufacturing contracts)
Both bills also provide that taxpayers meeting the new Section 448 gross receipts test would no longer be required to account for inventory under Section 471.
Contributions to capital
The House bill would significantly change the treatment of capital contributions to corporations. The Senate bill does not include this provision. Under current law, contributions to capital are generally excluded from corporate income under Section 118, and a corporation does not recognize gain or loss when receiving money or property in exchange for its stock under Section 1032. The legislation would include capital contributions in corporate income to the extent they exceed the fair market value of the stock received in exchange. If no stock was issued for such money or property, the entire contribution of capital would constitute gross income to the corporation. Similar rules would apply for partnerships. This provision is aimed at taxing the incentives some businesses receive from state and local governments.
The bill would also affect how the basis of contributed property to the corporation is determined. Currently, a corporation’s basis in property acquired in a contribution of capital from a shareholder is the shareholder’s previous basis plus any gain the shareholder recognizes on the transfer. However, there are limitations under Section 362(e) that may currently apply to the basis if such contributed property had built-in loss.
The bill provides that the basis for a contribution to capital would be the greater of the basis in the hands of the transferor plus any gain, or the amount included in gross income. The bill would also repeal rules that currently provide that a debtor corporation that acquires its debt from a shareholder as a capital contribution is treated as satisfying the debt with an amount of money equal to the shareholder’s adjusted basis in the debt. The changes would apply to contributions and transactions after the date of enactment.
The Senate bill includes an $8.9 billion revenue-raiser not in the House version that would revise the rules for revenue recognition. Under the provision, accrual taxpayers would be required to recognize income no later than the taxable year in which it is taken into account in the taxpayer’s applicable financial statements (or other financial statements as designated by Treasury). A last-minute change in the Senate bill provides an exception for mortgage-servicing rights.
Compensation and benefits
Both bills expand the limit on a public company’s ability to deduct compensation under Section 162(m). The exceptions for commissions and performance-based compensation would be removed for tax years starting in 2018 or later, meaning no compensation in excess of $1 million for covered employees would be deductible regardless of its character. The bill expands the definition of a covered employee to include the CFO, and the $1 million deduction limitation applies to a covered employee’s compensation in all future years, including after termination of employment or death. Under the Senate bill, these changes would not apply to compensation paid under a written binding contract that was in effect on Nov. 2, 2017, if the contract is not modified.
Grant Thornton Insight: This is a significant expansion of the limits on compensation deductions. Not only does it remove the exception for incentive compensation, but it expands the number of employees and officers affected. Many companies will have more than five covered employees when compensation continues after covered employees change their roles or leave the company.
Credit for leave
The modified Senate bill adds new provisions that would create a tax credit for certain employers that offers paid family and medical leave. The credit would be 12.5% of wages paid to qualifying employees in 2018 and 2019.
Both bills would result in a dramatic transformation in the ways corporations with international operations are taxed. After imposing a one-time tax on unrepatriated earnings, the bills would generally provide a shift from our current worldwide tax system toward a territorial approach where certain foreign earnings are exempt from tax. But the bills complicate this with minimum taxes, anti-base erosion proposals and limitations on interest deductions. Although the House and Senate versions share core principles in these areas, the actual proposals differ significantly in the details. See the table below for a comparison of the bills.
- Modifies certain provisions related to possessions of the United States
- Modifies attribution rules for determining CFC status
- Numerous other provisions
- Special rules to incentivize the repatriation of intangible assets
- Modifies definition of U.S. shareholder and attribution rules for determining CFC status
- Numerous other provisions
Both bills create a new 20% excise taxes on wages over $1 million paid by a tax-exempt organization to its highest paid employees beginning in 2018. The tax applies to any employee who was one of the five highest-paid employees in any year beginning in 2017 or later. The tax also applies to parachute payments.
Excise tax on foundations and colleges and universities
Both bills would amend the excise tax on net investment incomes of private foundations to create a flat 1.4% rate (with no ability to reduce the rate based on distributions), and expand it to cover net investment income of private colleges and universities for the first time. The provision would apply to private colleges and universities (not public state colleges or universities) that have at least 500 students during the preceding year and have an aggregate fair market value of assets (other than those assets used to carry out the exempt purpose of the institution) totaling at least $250,000 per student in the House version and $500,000 per student in the Senate version.
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