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Tax reform bill begins to take final shape

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Shaking hands near a justice scale and gavelRepublican tax reform legislation inched closer to a potential final version this week after the Senate Finance Committee made a number of key revenue changes.

There are still hurdles to enactment, including differences between the House and Senate bills, but the effort cleared two key milestones this week. The full House approved its version in a relatively comfortable 227-205 vote. The Senate Finance Committee approved its mark-up on a 14-12 party-line vote. More importantly, Senate tax writers finally unveiled the revisions they believe will make the bill compliant with reconciliation procedures.

Budget reconciliation allows for a simple majority vote in the Senate, but precludes any revenue loss outside of the 10-year budget window. The revisions would lower the projected revenue loss outside the budget window by permanently repealing the excise taxes on individuals who fail to obtain health coverage per the Affordable Care Act (often called the “individual mandate”), and sunsetting nearly every other individual provision at the end of 2025 (including the deduction for pass-throughs). The corporate rate cut and most other businesses provisions would remain permanent under the bill. Other key changes the Senate Finance Committee made before committee passage include:
  • Allowing professional service business owners with up to $600,000 (joint) or $300,000 (single) in taxable income to benefit from the deduction on pass-through business income
  • Requiring R&D expenses to be amortized over five years beginning in 2026
  • Removing an unpopular proposal re-writing nonqualified deferred compensation rules
  • Removing a proposed safe harbor for worker classification
  • Significantly expanding a provision denying deductions for certain government fines and penalties
  • Further limiting the deduction for net operating losses (NOLs) from 90% to 80% of income beginning in 2024

Senate Republicans believe the changes make the bill compliant with reconciliation, but that decision will ultimately be made by the Senate parliamentarian when a point of order is raised on the Senate floor. The parliamentarian would rely on the determination of official government scorekeepers. The Joint Committee on Taxation has not publicly released any analysis. Republican tax writers appear confident, and even added a provision that would repeal several business revenue-raisers in the future if government receipts meet certain targets.

Some of the revenue changes could make passage more difficult from a political perspective. Although the ACA’s individual mandate is considered unpopular, many members believe it keeps the health care exchanges viable by encouraging healthy individuals to join insurance pools. Its repeal is estimated to raise $318 billion over the next 10 years because government scorekeepers believe that without it, fewer people would purchase insurance and qualify for the associated tax credits. The JCT released a distributional analysis that showed taxpayers with under $30,000 in income actually facing a tax increase within the first 10 years under the bill. Although this appears to be the result primarily of repealing the individual mandate, Republicans have been sensitive to accusations that their bill would raise taxes on low-income taxpayers to pay for corporate and high-income tax cuts.

The expiration of the individual provisions in 2025 could also prove controversial. Individuals and pass-throughs would receive temporary tax relief, while corporations would receive permanent tax cuts. In fact, if the expiration of the individual provisions occurred as written, the legislation would represent an individual tax increase rather than a reversion to current law. Individuals would face higher taxes collectively because the bill would permanently repeal the individual mandate and slow inflation adjustments for the tax brackets. Due to these provisions, the bill is currently scored as raising revenue from individuals outside the budget window, and this revenue helps pay for the permanent corporate reform.

Of course, there would be many opportunities to address or extend the individual provisions before they expire. In the past, many temporary tax benefits were routinely extended for years. On the other hand, some partisan bills passed under reconciliation have proven difficult to retain. Key parts of the 2001 and 2003 tax cuts were ultimately allowed to expire, and Republicans appear to be on the verge or reversing at least one major aspect of the Affordable Care Act.

The Senate is expected to vote on the bill the week of Nov. 27. The outcome is difficult to predict because of the slim Republican majority. With just 52 seats, Republicans can lose only two votes and still pass the bill without Democratic votes. So far, Sen. Ron Johnson, R-Wis., is the only Republican senator to publicly state he currently opposes the bill, though others have expressed concerns. Johnson is unhappy with the pass-through business provisions. Sen. Susan Collins, R-Maine, has expressed concern about mixing health care legislation with tax reform. Further changes to the bill could be considered to attract the necessary votes or even as part of an effort pre-negotiate a compromise with the House.

Substantial differences remain in the House and Senate versions. House Speaker Paul Ryan R-Wis., said this week that the House would not simply accept the Senate bill, and he pledged to convene an official conference committee. But plans can change for political considerations and time constraints. Republican leaders are pushing to enact into law a final version before the end of the year. Several members suggested that the House and Senate could hold informal negotiations immediately and modify the bill so it is acceptable to the House before the Senate even votes on it.

The biggest challenge will likely be satisfying both moderate Senate Republicans and conservative House Republicans. The Senate may have more leverage in negotiations because their 52-seat majority leaves them little room to lose votes. But House members could demand concessions in key areas, including the effective date of the corporate rate cut.

The following includes more details on the major changes made to the Senate bill before committee passage. For an analysis of the original Senate bill (and changes to the original House bill), see “A House and Senate divided: Tax bill breakdown.” For an analysis of the original House bill, see "Unraveling the tax reform bill: What you need to know.”

Sunset provisions Under the modified Senate bill, all the provisions in Title I, with two exceptions, would expire Dec. 31, 2025. The two exceptions include the repeal of the individual mandate and the use of a slower inflation adjustment for the individual tax brackets. Title I otherwise includes all the tax changes affecting individuals, including the 17.4% deduction for pass-through income.

As a whole, the individual changes are estimated to reduce revenues by $683 billion over the next 10 years. This incorporates the repeal of the individual mandate, which raises $318 billion, and the new measure for inflation, which raises $134 billion. So if the sunset occurred as written, individual taxpayers would collectively lose tax cuts worth $1.135 trillion over 10 years, while continuing to be subject to tax increases estimated at $452 billion. The sunset provisions are meant solely to prevent scorekeepers from assessing the bill as losing revenue outside the budget window and violating reconciliation requirements. Republicans have indicated they would try to extend individual tax relief in future years.

Sunrise provisions The modified Senate bill also added several “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 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 modify international base-erosion rules. The modified bill would also impose new reporting requirements and associated penalties related to these provisions. Republicans hope to repeal these revenue increases before they take effect, and added a special provision to the bill that would repeal them automatically if certain revenue goals are met.

Individual changes The modified Senate bill makes several changes to the individual brackets proposed by the earlier version. Most significantly, the 22.5% and 32.5% brackets are reduced to 22% and 32% respectively. The modified Senate bill also provides an even bigger child credit of $2,000, with a higher income threshold. The original Senate bill provided an increase from the current $1,000 credit to $1,650. As stated earlier, these and nearly all other the individual changes would be set to expire in 2026 under the modified bill.

To repeal the individual mandate, the modified bill would reduce any excise taxes for individuals who fail to obtain coverage under ACA to zero beginning in 2019, and this change would be permanent.
Tax brackets for single and joint filers
Pass-through deduction The modified Senate bill makes significant improvements to the 17.4% deduction available for qualifying domestic pass-through business income. The provision as introduced was generally limited to 50% of wages paid by the business owners (presumably based on the owner’s distributive, or pro rata, share of pass-through wages paid), and completely excluded certain specified service businesses. For taxpayers with up to $250,000 (single) or $500,000 (joint) in taxable income, the modified version would remove the wage restriction and allow the deduction for owners of specified service businesses. The wage limit would phase in for single taxpayers from $250,000 to $300,000 in taxable income and from $500,000 to $600,000 for joint filers. The deduction as a whole would phase out over an identical range for owners of specified service businesses. Under the bills sunset provisions, the deduction would expire altogether for all taxpayers in 2026.

Business provisions Net operating losses The chairman’s mark adds a stricter limit on NOL deductions beginning in five years. The House bill and the original Senate proposal limited the NOL deduction to 90% of taxable income beginning in 2018. The modified Senate bill retains the 90% limitation through 2022, after which NOLs are limited to 80% of taxable income. Under a special provision, the 80% limit would not take effect if certain revenue targets are hit.

The modification also exempts property and casualty insurance companies from the new regime, meaning their NOLs would continue to use a two-year carry-back and a 20-year carry-forward without any taxable income limit.

Interest deduction The modified Senate bill generally retains the original limit on the interest expense deduction, but allows certain farms to elect out of if they give up the right to accelerated cost recovery for certain farm equipment. This provision expands the same treatment to farming businesses as was afforded to real estate businesses in the original version.

Expensing The modified Senate bill expands the property eligible for 100% bonus depreciation to include qualified film, television and live theatrical productions (as defined in section 181(d) and (e)). Consistent with the underlying bill, this property would qualify for expensing if placed in service after Sep. 27, 2017, and before Jan. 1, 2023.

Real property The modified Senate bill would also shorten the recovery period for residential real property from 40 to 30 years under the alternative depreciation system. The underlying bill would still reduce the recovery period for both residential and commercial real property to 25 years under the modified accelerated cost recovery system (MACRS).

R&D expensing The modified Senate bill adds a House provision that would repeal the current deduction for specified R&D expenses (including software development costs) and require the expenses to be capitalized and amortized over five years (15 years for foreign expenses). The Senate version would not become effective until tax years beginning after Dec. 31, 2025, and is meant as a revenue-raising provision to comply with reconciliation instructions on losses outside the budget window. A special provision would prevent the change from taking effect as scheduled if specific revenue targets are hit. If effective, the provision could create a large burden on taxpayers who currently may not identify all of their Section 174 expenditures and would be required to perform research expense studies. The provision could also deter taxpayers from pursuing in-house software development as software purchases would be recovered over three years, while any research costs for software would be amortized over five years.

Deductions for government fines and penalties The modified Senate bill adds a new provision that expands the denial of deductions for fines and penalties paid to or at the direction of a government entity. Under the provision, any amounts related to restitution, remediation or required compliance with any law would not be deductible unless they were identified in the court order or settlement agreement as such. The proposal requires government agencies to report to the IRS and the taxpayer the amount of each settlement agreement or order where the amount is at least $600. The reporting must separately identify any amounts that are for restitution, remediation of property or correction of noncompliance. This proposal has existed for years, and has been criticized in the past for being overly broad. It could capture ordinary compliance costs and create a large burden for taxpayers and local governments. It would be effective for amounts paid or incurred after the date of enactment.

Deductions for sexual harassment or abuse settlements The modified Senate bill adds a provision denying any deduction for any settlement, payout or attorney fees related to sexual harassment or sexual abuse if payments are subject to a nondisclosure agreement. This is effective for amounts paid or incurred after the date of enactment.

Meal deduction The modified Senate bill fully disallows an employer’s deduction for expenses associated with meals provided on the employer’s business premises or provided on or near the employer’s business premises through an employer-operated facility. The original Senate bill limited these expenses to 50%. This is a “sunrise” provision not scheduled to take effect until 2026, and a special provision would repeal it if specific revenue targets are hit.

Citrus expensing The modified Senate bill expands a current law provision allowing for immediate expensing of certain costs for replanting citrus plants after casualty losses suffered by another taxpayer.

Alcohol-related tax rules The modified Senate bill adds a whole package of favorable changes to the tax rules related to alcohol, including:
  • Exempting the aging period of beer, wine and spirits from UNICAP rules related to interest
  • Reducing the excise tax rate on beer from $18 per barrel to $16 for the first 6 million barrels (with an even lower rate for small brewers)
  • Instructing Treasury to simplify reporting and filing responsibilities
  • Relaxing the rules for bonded tax-free transfers of beer
  • Removing restrictions on the credit against wine excise taxes for small domestic producers
  • Increasing the alcohol percentage limit for wine taxed at the lowest rate
  • Reducing the tax rate on mead and certain sparkling wines
  • Reducing the tax rate on the first $22,130,000 “proof gallons” of distilled spirits
  • Allowing transfer of bonded spirits in bottles

Electing small business trusts The modified Senate bill added a provision that would allow electing small business trusts (ESBTs) to name nonresident aliens as beneficiaries, even though such individuals still would not be permitted as S corporation shareholders. The modified Senate bill would also provide that ESBT charitable contributions would be subject to individual restrictions and requirements and not the rules that govern trusts.

Tax credits The modified Senate bill restores the 20% rehabilitation credit for certified historic structures, which was reduced to 10% in the original Senate bill. The modified Senate bill would also further reduce and limit the “orphan drug” credit.

Compensation and benefits The modified Senate bill removes four provisions that were included in its original mark-up:
  • New rules on nonqualified deferred compensation
  • Worker classification safe harbor
  • Limit on the ability for taxpayer to make catch-up contributions
  • 10% early withdrawal penalty on governmental Section 457(b) plans

None of the provisions were included in the final House bill, though the first draft of the House bill proposed the new rules on nonqualified deferred compensation. Much like in the Senate, it was removed by the House Ways and Means Committee due to significant opposition.

The modified Senate bill adds three House provision that were not originally included in the Senate bill. These provisions would:
  • Disallow recharacterizations of Roth IRA rollovers
  • Extend the time taxpayers have to repay a loan from a retirement plan after employment or the plan is terminated
  • Create new qualified equity grant rules to allow private company employees to defer income recognition on certain stock options and restricted stock units

The modified Senate bill provides transition relief for a provision included in both the House and Senate bill that expand the limit on a public company’s deduction for compensation under Section 162(m). Under the modified 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. Based on language in a last-minute manager’s amendment, is unclear whether the compensation must be vested on or before Dec. 31, 2016, to qualify for the transition rules.

The modified Senate bill adds new provisions that would create a tax credit for certain employers that offer paid family and medical leave. The credit would be 12.5% of wages paid to qualifying employees in 2018 and 2019. The modified Senate bill would also increase the contribution limits for ABLE accounts and allow Section 529 plans to be rolled into ABLE accounts without penalty. These two provisions are included in the individual title, and are therefore scheduled to expire in 2026.

International tax Despite major shifts in other areas of the bill, the international provisions remained largely unchanged. The modified bill added two new proposals that change certain sourcing rules involving possessions, and repealed exclusions for certain aircraft operated by a foreign corporation. It also made a number of minor modifications to the base-erosion provisions and transition rules proposed in the bill.

The most significant change adds an election to preserve NOLs upon transition to the proposed territorial system. The modified bill allows taxpayers to opt out of using NOLs to offset the mandatory one-time tax on unrepatriated earnings.

Other changes to the intentional provisions include:
  • Reducing the deduction available to offset “global intangible low-taxed income” for taxable years beginning after Dec. 31, 2025
  • Reducing the deduction (from 37.5% to 21.875%) available to offset “foreign-derived intangible income” for taxable years beginning after Dec. 31, 2025
  • Increasing the tax rate (from 10% to 12.5%) used when computing the base-erosion minimum tax imposed when certain companies engaged in excess base erosion for taxable years beginning after Dec. 31, 2025
  • Modifying the base-erosion minimum tax in several ways, including exempting certain intercompany services which are charged at no mark-up.

With the exception of the exemption for certain intercompany services, these changes are designed as “sunrise” provisions that raise revenue outside the budget window to be compliant with reconciliation rules. The modified bill includes a special provision that would prevent these changes from taking effect as scheduled if specific revenue targets are met.

Tax administration The modified Senate bill, unlike the bill passed in the House, adds several modest provisions impacting tax administration, including acknowledging IRS budget cuts and “expressing the sense of the Senate that politically motivated budget cuts are counterproductive to deficit reduction.”

The modified bill would extend the time period under Section 6532 from nine months to two years for a taxpayer to bring suit against the IRS for returning monetary proceeds from the sale of property that has been wrongfully levied-. The legislation would also prohibit the IRS from increasing the amount of user fees charged for installment agreements, while alleviating user fee requirements for lower-income taxpayers.

The legislation would also direct the IRS to publish a new, simplified individual income tax return, known as the Form 1040SR, which would be similar to the Form 1040EZ. This form would not be restricted based on the amount of taxable income required to be shown on the return, or the fact that income for the taxable year may include Social Security benefits, distributions from qualified retirement plans, annuities or other deferred payments, or other forms of passive income.

Gain more insights on tax reform

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Director, Washington National Tax Office
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David Sites
Partner, Washington National Tax Office
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Partner, Washington National Tax Office
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