November 28, 2017

Tax Cuts and Jobs Act of 2017

Noteworthy

Background: The Senate Finance Committee passed the Tax Cuts and Jobs Act of 2017 out of committee on November 16 by a vote of 14-12.

Floor Situation: The Senate is expected to consider this legislation the week of November 27.

Executive Summary: The bill would lower individual, small business, and corporate tax rates. It nearly doubles the standard deduction, effectively eliminates Obamacare’s individual mandate, increases the child tax credit, eases the burden of the estate tax, and includes other provisions lowering taxes for individual people and families. For small businesses, the bill includes a deduction to lower the marginal tax rate applied to pass-through business income. For corporations, the bill lowers the tax rate to 20 percent, moves to a territorial tax system for international operations, and simplifies the corporate tax code. The bill also repeals both the individual and corporate alternative minimum tax.

Consideration on the Bill

The tax code was last reformed in 1986. Since then, the tax code has grown in length and complexity; complying with the tax code takes families and businesses 6 billion hours a year, at a cost of $263 billion. The U.S. has the highest corporate tax rate in the developed world, and the international tax system imposes a second layer of tax on a corporation that brings profits back to the U.S. from overseas.

It is estimated that tax reform would cause average household income to rise by $4,000, cause wages to increase between 4 percent and 7 percent, and result in a U.S. economy that is 3 to 5 percent larger.

The Joint Committee on Taxation estimates that the bill reported by the Finance Committee will reduce revenues by $1.414 trillion from 2018-2027, based on a current law baseline. For more detail on any provision discussed in this notice, JCT has provided technical explanations on its website for the chairman’s mark and the modification to the mark. The Finance Committee has also provided a section-by-section of the bill as reported from committee, available here.

Notable Bill Provisions

Tax Reform for Individuals

Simplification of Tax Rates

The bill lowers marginal tax rates and keeps the number of tax brackets at seven. The new tax brackets are 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 38.5 percent.

All tax parameters that are currently indexed to the consumer price index will instead be indexed to chained CPI-U. Chained CPI-U more accurately reflects actual consumer costs because it allows for the fact that consumers can switch to less expensive substitute goods when prices rise. Unlike the rest of this title, the move to chained CPI-U does not expire after December 31, 2025.

Increase in the standard deduction

The bill would nearly double the standard deduction to $24,000 for joint filers, $18,000 for heads of households, and $12,000 for single filers. These amounts will be indexed for inflation using chained CPI-U. Under current law, people may itemize their deductions or take the standard deduction. The standard deduction for tax year 2017 is $12,700 for joint filers, $9,350 for heads of households, and $6,350 for single filers. JCT estimates that this increase in the standard deduction will result in approximately 95 percent of taxpayers taking the standard deduction, up from the nearly 70 percent who take the standard deduction currently.

Repeal of personal exemptions

The bill repeals the deduction for personal exemptions. Under current law, taxpayers are allowed to reduce their adjusted gross income for themselves and dependents by a personal exemption of $4,050 in 2017.

Effective repeal of Obamacare’s individual mandate

Beginning in 2014, Obamacare requires everyone to either purchase a government-approved health care plan or pay a tax, known as the individual mandate penalty. In 2017, the amount of the tax is 2.5 percent of income or $695, whichever is greater. The tax reform bill reduces the penalty amount to zero dollars beginning in tax year 2019, effectively repealing Obamacare’s individual mandate tax.

Earlier this month, the Congressional Budget Office estimated that repealing the mandate tax would save $338 billion between 2018 and 2027 and increase the number of uninsured by 13 million in 2027. The savings come from the assumption that 5 million fewer people would enroll in Medicaid in the absence of the tax, which would reduce federal spending on Medicaid by $179 billion between 2018 and 2027. They also estimate that 5 million fewer people would enroll in coverage in the non-group market, including the federally subsidized exchange market, which would reduce federal spending on Obamacare’s subsidies by $185 billion. In addition, they estimate that 2 million people would no longer have employer-sponsored coverage and that other effects would reduce federal spending or increase revenues by $62 billion, mainly due to changes in taxable compensation.

In November 2017, JCT estimated that reducing the individual mandate tax to zero, different from a repeal, beginning in 2019 would save $318 billion over ten years.

Obamacare’s premium tax credits are distributed through the tax code and only available to people with incomes between 100 percent and 400 percent of the federal poverty level. For an individual, that translates to an income range of $12,060 to $48,240 this year. For a family of four, it is an income between $24,600 and $98,400.

When individuals receiving premium tax credits chose to drop their coverage, they lose their tax credit. Thus, JCT’s distribution tables purport to show greater tax liability for lower-income households under the tax reform bill compared to under current law. This reflects the decrease of the portion of $185 billion attributable to the reduction in individuals receiving Obamacare’s premium tax credits.

However, the bill would not force anyone to change health insurance coverage. Eligibility for Obamacare’s premium tax credits would not change, and the amount that people qualifying for credits would have to pay would not change. Eligibility for Medicaid and employer-sponsored coverage would not change under this bill. Those who drop their insurance coverage when the mandate tax is effectively repealed would be choosing to do so – a voluntary behavior.

JCT and CBO both issued distributional tables for the tax reform bill excluding the effects of the individual mandate tax repeal, and all income categories receive a tax cut under the bill through 2025.

Increase in Child Tax Credit

The child tax credit is increased to $2,000 from the current $1,000. The income level at which the credit begins to be phased out will be $500,000 for joint filers, an increase from the current $110,000. Up to $1,000 of the credit may be refundable, indexed to inflation and rounded up to the nearest $100. In order to receive the refundable portion of the credit, a taxpayer must provide a Social Security number for each qualifying child.

Simplification and reform of deductions and exclusions

The bill would repeal or modify several tax deductions and exclusions, including the following:

  1. Home mortgage interest deduction. The bill keeps current law treatment for mortgages taken in acquiring a home but repeals the deduction for interest with respect to home equity loans.

  2. Tax preparation expenses. The bill would repeal the deduction for tax preparation expenses.

  3. Repeal of deduction for taxes not paid or accrued in a trade or business. The bill repeals the deduction for state and local income tax, state and local sales tax, or state and local property tax. These deductions will still be allowed if the state or local tax was paid or accrued in carrying on a trade or business or with respect to property held for the production of income.

  4. Repeal of overall limitation on itemized deductions. The bill repeals the limit on itemized deductions. Under current law, the total amount of itemized deductions is limited for taxpayers earning more than: $313,800 for joint filers; $287,650 for heads of household; $261,500 for single filers; or $156,900 for married people filing separately.

  5. Modification of exclusion of gain from sale of a principal residence. The bill would (1) increase the required amount of time a taxpayer has used a residence as a principal residence in order to qualify for this exclusion, and (2) limit how often the taxpayer can use this exclusion. Under current law, a taxpayer may exclude up to $500,000 for joint filers, or $250,000 for all other filers, of the gain realized from the sale of a principal residence. The residence must have been used as a principal residence for two of the last five years. Under the bill, the exclusion is the same dollar amount, but the residence must have been used as a principal residence in five of the last eight years. The bill also only allows a taxpayer to use this exclusion once every five years; current law allows its use once every two years.

Treatment of pass-through business income

Pass-through businesses are S corporations, sole proprietorships, or partnerships. Limited liability companies are organized under state law, but are treated as partnerships for federal tax purposes. These business organizations pass their profits directly to their owners without being taxed at the business level. The business owner pays tax on business profit on his or her personal tax returns.

To reduce the tax burden on pass-through business owners, the Senate bill would allow an individual taxpayer to deduct 17.4 percent of qualified business income. This avoids having separate rates for individual wage income versus pass-through business income, while still providing a lower effective rate to pass-through businesses.

The House bill addresses this issue by adopting a maximum 25-percent rate for qualifying pass-through income, which is based on a 70/30 rule: 70 percent of pass-through business income is deemed to be wage income, while 30 percent is deemed to be business income. The lower pass-through rate is then applied to the 30 percent of business income, while the individual tax brackets are applied to the 70 percent of business income.

Estate and gift taxes

The bill would double the exemption amount for the federal estate, gift, and generation-skipping transfer taxes from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011. For 2017, the exemption amount is $5.49 million per person.

529 education savings accounts for the in utero

The bill would allow a child in utero to be designated as a beneficiary of a 529 education savings account. The bill defines a child in utero as being a child carried in the womb, regardless of the stage of development.

Doubled deduction for educator expenses

Current law allows teachers to deduct up to $250 of educational expenses when using their own funds. The bill doubles this to $500.

Unaffected provisions

While the bill modifies or repeals many deductions and credits, notable provisions that are preserved by this bill include: charitable contributions; child and dependent care credit; adoption tax credit; earned income tax credit; 401(k) and individual retirement accounts; medical expenses deduction; the blind and elderly’s enhanced standard deduction; and provisions for graduate students.

Expiration

Under the bill, provisions in this title take effect for tax year 2018 and will expire after December 31, 2025. Repeal of the individual alternative minimum tax, included in a separate subtitle, also expires at the same time. The delay is necessary to comply with a budget point of order against long term deficits; however, this title could be made permanent if 60 votes were available to waive this point of order.

Business Tax Reform

The bill simplifies the corporate tax code, and makes this title permanent. Although many provisions of current law are altered, the bill preserves two notable provisions of current law: the research and development credit; and the low-income housing credit for business investment in low-income housing.

Corporate tax rate reduction

The bill lowers the corporate income tax rate to 20 percent. Currently, the top corporate income tax rate is 35 percent, the highest in the Organization for Economic Cooperation and Development. The bill also adjusts the corporate dividends-received deduction to correspond to the new 20 percent rate.

Cost recovery – expensing and bonus depreciation

A business generally must capitalize the cost of property used in the business, with the recovery of the cost achieved through depreciating the property or by expensing it. The methods can also be used together, expensing part of the cost and depreciating the balance. The bill includes modifications to both:

  1. Section 179 expensing. This allows businesses to deduct the full cost of a piece of equipment used in a business, rather than depreciating it over many years. The bill increases the section 179 expensing maximum deduction from $500,000 to $1,000,000. A phase-out begins when the total cost of property placed in service during the year exceeds $2,500,000.

  2. Bonus depreciation. If a business depreciates its property, an additional first year depreciation deduction – or “bonus depreciation” – is allowed under current law through 2019 (or 2020 in certain cases). Under current law, in 2017 the percentage of the property’s cost that can be depreciated in the first year is 50 percent. The percentage decreases in future years until it expires at the end of 2019. The bill would increase bonus depreciation to 100 percent for property placed in service after September 27, 2017, through 2022 (or 2023 in certain cases).

Net interest limitation

Under current law, interest expenses of a business are generally deductible, subject to certain limits. The bill would limit this interest to 30 percent of the business’ income after adding back interest and taxes. The business could then carry forward any interest amounts above this threshold, with no limit to the number of years that the excess interest could be carried forward before it is claimed as a deduction against future income. Certain exceptions are provided for small businesses, real estate businesses, and farming businesses.

Modification of net operating loss deduction

The bill limits the amount of a net operating loss from a prior year that a business can deduct to 90 percent of the current year’s taxable income.

Repeal of like-kind exchanges of real property

Under current law, like-kind exchanges of most types of business property are generally not treated as a taxable event, and any gain is deferred. The bill limits like-kind exchanges to real property that is not held primarily for sale.

Amortization of research and experimental expenditures

Beginning in 2026 unless certain revenue targets are met, the bill would require certain research and experimental expenditures to be capitalized and amortized over a five-year period, rather than being deducted in a single year.

Employer credit for paid family and medical leave

The bill creates a new business tax credit for employers who provide paid family and medical leave to their employees. The credit is 12.5 percent to 25 percent of the wages paid to an employee when on family and medical leave, depending on the percentage of the typical wage paid to the employee.

Repeal of deduction for income attributable to domestic production activities

Current law provides a section 199 deduction for qualified domestic production activities. This has the effect of reducing the corporate tax rate on domestic production activities from 35 percent to less than 32 percent. The bill repeals this deduction, since the new corporate rate will be 20 percent, and pass-through businesses will benefit from the new deduction for pass-through income.

Limitation on deduction by employers of expenses for fringe benefits

Current law allows a deduction for costs incurred in providing fringe benefit activities that are entertainment, amusement, recreation, or club membership dues, as long as the business establishes that these expenses are related to conducting a trade or business. The bill would repeal this deduction. Businesses are also permitted to deduct certain transportation benefits and costs of meals provided to employees. The bill limits these deductions.

Limitation on deduction for FDIC premiums

The bill limits the ability for financial institutions to deduct the premiums paid to the Federal Deposit Insurance Corporation for deposit insurance. For institutions with less than $10 billion in assets, 100 percent of premiums are deductible. For institutions with over $50 billion in assets, none of the premiums are deductible. For institutions between these two values, the limitation is phased in.

Craft beverage modernization and tax reform

The bill includes various provisions lowering the excise taxes on beer, wine, and distilled spirits.

First-in first-out for sale of specified securities

The bill requires the cost basis for specified securities, e.g., stock, to be determined on a first-in first-out basis unless the average-basis method is allowed, such as for mutual funds.

Qualified opportunity zones

The bill creates a process to designate certain low-income areas as “qualified opportunity zones.” The tax incentives provided to encourage investment in these zones are (1) deferral of tax on capital gains that are reinvested in a qualified opportunity fund, and (2) no tax on the capital gains from investments in these funds, if the investment in the fund is held for at least 10 years. 

International Tax Reform

Currently, the United States has a worldwide tax system. Under this system, a corporation headquartered in the U.S. must pay the corporate income tax on all of its income, regardless of whether it is earned in the U.S. or overseas. However, the tax is only due when the foreign earnings are brought back to the U.S. This is known as “deferral,” because the income tax owed can be deferred until a later date when the income is repatriated. When a business chooses to repatriate earnings and pay the U.S. corporate income tax, the law also allows what was paid to a foreign government as a credit against the U.S. tax that the corporation would otherwise have to pay, subject to certain limitations.

In the 1980s, 24 countries in the OECD had a worldwide tax system. The tax rates of most countries were comparable to the U.S. After the Tax Reform Act of 1986 brought the U.S. corporate rate down to 34 percent, the U.S. had a lower rate than most other developed nations. After the U.S. lowered its rate, other countries began to lower their rates and move to a territorial system. Today only seven OECD nations have worldwide tax systems, while 28 have territorial systems. Ireland kept its worldwide system, but lowered rates to 12.5 percent. In contrast, the U.S. has both the highest corporate rate of any OECD country and also a worldwide system.

Territorial tax system

The bill would move the U.S. to a territorial tax system. It does this by allowing U.S. corporations to deduct 100 percent of the payments they receive from their foreign subsidiaries, provided the U.S. corporation owns at least 10 percent of the foreign corporation. This has the effect of exempting the foreign income from the second layer of U.S. tax that is imposed under the current worldwide system.

Deemed repatriation

The bill includes deemed repatriation, an approach necessary to make the transition to a territorial tax system. Under the bill, the accumulated foreign earnings of U.S. corporations are treated as if they were repatriated, and a tax rate of 10 percent will be applied to cash or easily liquidated assets. A 5 percent rate will apply to fixed assets, e.g., a factory overseas financed with past overseas profits. Businesses can elect to pay the tax due in installment payments over eight years.

Base erosion rules

The bill also includes a number of provisions to prevent companies from moving their operations offshore simply to take advantage of the new territorial tax system and to guard against base erosion. These base-erosion provisions include new rules relating to intangible income, such as from patents and copyrights, and incentives for U.S. companies to repatriate foreign-held intellectual property back to the U.S. The bill also includes a provision that imposes a minimum tax on large corporations – those with more than $500 million in receipts – that have a significant percentage of base-erosion payments – payments between the domestic corporation and related foreign parties that are deductible for purposes of U.S. tax. The minimum tax owed is determined by formula depending on the circumstances of a corporation’s receipts, tax credits, and related-party payments.

Alternative Minimum Tax Repeal

The bill would repeal both the individual and the corporate alternative minimum tax. The individual AMT repeal would expire after December 31, 2025.

Administration Position

A Statement of Administration Policy has not been released, however administration officials have offered statements praising the bill.

Cost 

The Joint Committee on Taxation estimates that the bill as reported by the Finance Committee will reduce revenues by $1.414 trillion from 2018-2027, based on a current law baseline.

Amendments

As a reconciliation bill, the Tax Cuts and Jobs Act will be debated for up to 20 hours. Amendments can be considered before all debate time is used. Many amendments may be considered after all debate time is used, in a “vote-a-rama.”