CAMP S US TAX REFORM PROPOSAL: WHAT S INSIDE?

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1 US TAX REFORM ALERT MARCH 2014 CAMP S US TAX REFORM PROPOSAL: WHAT S INSIDE? By Evan Migdail, Linda Pfatteicher and Bruce Thompson House Ways and Means Committee Chairman Dave Camp (R-Michigan) this week introduced a draft of the most comprehensive reform of the Internal Revenue Code in decades. The key principles in the draft are: 1. a deep reduction in individual and corporate tax rates 2. elimination of numerous tax expenditures in exchange for the lower rates (the draft, for example, would eliminate all of the business credits that expired at the end of 2013 except for the credit for research which would become permanent as described below) 3. establishment of a new competitive international tax system based on a dividend-exemption system and the expansion of Subpart F for certain foreign income and 4. simplification reforms, both in the substantive tax area and in tax administration. The Camp plan will contribute to the continuing debate on tax reform among policy makers in Washington. The new Chairman of the Senate Finance Committee, Ron Wyden (D-Oregon), the author himself of a comprehensive tax reform proposal in the last Congress, is expected to unveil his own plans for tax reform in the near future. In this review, we analyze key provisions of the Camp plan, looking at current law, Camp s proposals and their potential impact. We cover every aspect of this massive proposal. INDIVIDUAL INCOME TAX I. Individual tax rates (Sections ) A taxpayer generally determines individual tax liability by identifying the applicable bracket within which such individual s regular taxable income falls and adding the amount of tax specified in that bracket to the product of (i) the rate associated with that bracket multiplied by (ii) the excess of regular taxable income over the lower threshold of that bracket. There are seven regular individual income tax brackets of 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. The income levels for each bracket threshold are indexed annually based on increases in the Consumer Price Index (CPI). A separate rate schedule

2 applies to adjusted net capital gain and qualified dividends, with rates of 0%, 15% and 20%. Additional special rates of 25% and 28% apply to certain kinds of capital gain. The current seven tax brackets would be reduced to three: 10%, 25% and 35%. The schedule for married persons filing a joint return would be: Taxable Income Not more than $71,200 More than $71,200 Tax 10% of regular taxable income $7,120 plus 25% of regular taxable income in excess of $71,200 For single filers, the new 25% bracket would begin at $35,600. Taxpayers having taxable income of more than $450,000 (35% threshold) ($400,000 for single filers) would compute their tax as the sum of the tax computed under the foregoing table plus 10% of the excess of modified adjusted gross income (MAGI) over the 35% threshold. Starting in 2015, these income levels would be indexed for chained CPI instead of CPI, a slightly different measure of inflation. The MAGI definition would prevent the 35% bracket from applying to qualified domestic manufacturing income (QDMI) so that such income would be taxed at a maximum rate of 25%. QDMI generally would include net income attributable to gross receipts derived from manufacturing, producing, growing or extracting tangible personal property in whole or in significant part within the United States, or constructing real property in the United States as part of the active business. The MAGI definition would also cause certain deductions and exclusions from gross income to reduce taxable income in the 25% or lower bracket only, but not taxable income in the 35% bracket. Affected items include the standard deduction; all itemized deductions except the deduction for charitable contributions, the deduction for contributions to Health Savings Accounts and the deduction for health premiums of the self-employed; the exclusions for foreign earned income, tax exempt interest; employer contributions to health, accident and defined contribution retirement plans and the excluded portion of Social Security benefits. For high-income taxpayers, the benefit of the 10% bracket measured as the difference between what the taxpayer pays and what the taxpayer would have paid had the first dollar of taxable income been subject to the 25% bracket would be phased out at a rate of $5 of tax savings for every $100 of MAGI in excess of $250,000 (single filers) or $300,000 (joint filers). These thresholds are adjusted for chained CPI in tax years after The special rate structure for net capital gain would be repealed. Instead, non-corporate taxpayers could claim an above-the-line deduction equal to 40% of adjusted net capital gain the sum of net capital gain and qualified dividends, reduced by net collectibles gain, as these items are defined under current law. The provision would generally be effective for tax years beginning after But, the exemption of QDMI from the 35% bracket would be phased in over three years, with only one-third of QDMI being excluded from the top bracket in tax year 2015, and two-thirds being excluded in The new manner of taxing income in the highest bracket would, in effect, make interest on state and local municipal obligations (net of related expenses) subject to a 10% tax. This is likely to depress demand for tax-exempt municipal obligations. Net capital gain and qualified dividend income would be taxed at a maximum rate of 24.8% (taking into account the 3.8% tax on net investment income imposed by the Patient Protection and Affordable Care Act, often called the Health Care Act), a slight decrease in the top effective rate under current law (which is 25% taking into account the 3.8% tax under the Health Care Act and the impact of the overall limitation on itemized deductions under Section 68). In general, ordinary income arising from a profitable business would be taxed at a maximum rate of 38.8% (taking into account the 3.8% tax imposed by the Health Care Act), a decrease of 5.8% from the current maximum rate at which such income is taxed. Under the proposal, a dollar of profit earned by a C corporation and distributed to its shareholders (net of the proposed 25% corporate level tax) would be subject to an effective rate of 43.6%. Thus, the current law bias in favor of operating a privately held profitable business in a passthrough entity (e.g., a partnership or S corporation) rather than a C corporation should continue under the proposal. If such a business involves manufacturing, production or other activities that can qualify as QDMI, the bias becomes more pronounced as the effective rate on the passthrough entity business owner drops to 28.8%. II. Changes to certain deductions, exclusions and certain other provisions (Sections 1401 through 1422) a. Exclusion of gain from sale of a principal residence. A taxpayer may exclude from gross income up to $500,000 for joint filers ($250,000 for other filers) of gain on the sale of a principal residence. The property generally must have been owned and used as the taxpayer s principal residence for two out of the previous five years. A taxpayer may only use this exclusion once every two years. 2 US Tax Reform Alert

3 . A taxpayer would have to own and use a home as the taxpayer s principal residence for five out of the previous eight years to qualify for the exclusion and the taxpayer would only be able to use the exclusion once every five years. The exclusion would be phased out by one dollar for every dollar by which a taxpayer s MAGI exceeds $500,000 ($250,000 for single filers). The provision would be effective for sales and exchanges after b. Mortgage interest. A taxpayer may claim an itemized deduction for mortgage interest paid with respect to a principal residence and one other residence of the taxpayer. Itemizers may deduct interest payments on up to $1 million in indebtedness incurred to acquire, construct or substantially improve the residence, and up to $100,000 in home equity indebtedness. Under the alternative minimum tax (AMT), the deduction for home equity indebtedness is disallowed.. A taxpayer may continue to claim an itemized deduction for interest on acquisition indebtedness, but the $1 million limitation would be reduced to $500,000 in four annual steps, so that it would be $875,000 for debt incurred in 2015, $750,000 for debt incurred in 2016, $625,000 for debt incurred in 2017 and $500,000 for debt incurred thereafter. Iinterest on home equity indebtedness incurred after the effective date would no longer be deductible. The provision would generally be effective for interest paid on debt incurred after In the case of a refinancing of debt incurred during the phase-in period, the refinancing debt generally would be treated as incurred on the same date that the original debt was incurred for purposes of determining the limitation amount applicable to the refinancing debt. c. Charitable contributions. A taxpayer may claim an itemized deduction for charitable contributions made during the taxable year. The charitable contribution deduction is limited to a certain percentage of the individual s adjusted gross income (AGI). Cash contributed to public charities, private operating foundations and certain non-operating private foundations may be deducted up to 50% of the donor s AGI. Contributions that do not qualify for the 50% limitation (e.g., contributions to private foundations) may be deducted up to the lesser of (1) 30% of AGI, or (2) the excess of the 50% limitation over the amount of charitable contributions subject to the 30% limitation. Capital gain property contributed to public charities, private operating foundations and certain non-operating private foundations may be deducted up to 30% of AGI. Capital gain property contributed to non-operating private foundations may be deducted up to the lesser of (1) 20% of AGI or (2) the excess of the 30% limitation over the amount of property subject to the 30% limitation for contributions of capital gain property. In general, qualified conservation contributions (e.g., conservation easements) are subject to the 30% limitation. If an individual contributes more than the applicable AGI limits, the excess contribution generally may be carried over and deducted in the following 5 tax years, or 15 years in the case of qualified conservation contributions. In general, taxpayers may deduct the fair market value of a charitable contribution. A variety of complex rules under current law, however, limit the amount of a charitable deduction to less than fair market value (e.g., the taxpayer s adjusted basis) based on the type of property and charitable organization receiving the contribution. A charitable deduction is generally disallowed to the extent a taxpayer receives a benefit in return. A special rule, however, permits taxpayers to deduct as a charitable contribution 80% of the value of a contribution made to an educational institution to secure the right to purchase tickets for seating at an athletic event in a stadium at that institution. The value of a deduction for intellectual property is generally limited to the property s adjusted basis. Under current law, however, the donor is allowed an additional deduction equal to a percentage of the income generated by the intellectual property over the 12 years following the contribution, even if that income is earned by a taxexempt entity.. The rules applicable to charitable contributions would be changed as follows, effective, except as otherwise indicated, for tax years after Extension of time to file: Iindividual taxpayers would be permitted to deduct charitable contributions made after the close of the tax year but before the original due date of the return for such tax year. AGI limitations: The AGI limitations would be substantially simplified: The 50% limitation for cash contributions and the 30% limit for contributions of capital gain property to public charities and certain private foundations would be converted into a single limit of 40%. The 30% limit for cash contributions and the 20% limit for contributions of capital gain property that apply to organizations not covered by the current 50% limit would be converted into a single limit of 25%. This type of contribution would be allowed to the extent the aggregate amount thereof does exceed the lesser of (1) 25% of AGI or (2) the excess of 40% of AGI for the tax year over the amount of charitable contributions subject to the 25% limitation. 3 US Tax Reform Alert

4 The 2% floor: An individual s charitable contributions could be deducted only to the extent they exceed 2% of the individual s AGI. The reduction would apply to charitable contributions in the following order: first, to contributions subject to the 25% of AGI limit, second, to qualified conservation contributions and third, to contributions subject to the 40% limitation. Value of deduction generally limited to adjusted basis: The amount of any charitable deduction generally would be equal to the adjusted basis of the contributed property. For the following types of property, however, the deduction would be based on the fair market value of the property less any ordinary gain that would have been realized if the property had been sold by the taxpayer at its fair market value: tangible property related to the exempt purpose of the donee exempt organization any qualified conservation contribution any qualified inventory contribution any qualified research property publicly traded stock and inventory contributed solely for the care of the ill, needy or infants. College athletic event seating rights: The special rule that provides a charitable deduction of 80% of the amount paid for the right to purchase tickets for athletic events would be repealed. Income from intellectual property: Income from intellectual property contributed to a charitable organization would no longer be allowed as an additional deduction by the donor. d. Denial of deduction for expenses attributable to the trade or business of being an employee. A taxpayer generally may claim a deduction for trade and business expenses, regardless of whether the taxpayer itemizes deductions or take the standard deduction. Expenses relating to the trade or business of being an employee are deductible only if the taxpayer itemizes deductions. Certain expenses attributable to the trade or business of being an employee, however, are allowed as above-the-line deductions, including reimbursed expenses included in the employee s income and certain other expenses.. A taxpayer would not be allowed an itemized deduction for expenses attributable to the trade or business of performing services as an employee. In addition, the only above-the-line deductions allowed for expenses attributable to the trade or business of being an employee would be those for reimbursed expenses and certain expenses of members of reserve components of the United States military. The provision would be effective for tax years beginning after e. Repeal of deduction for taxes not paid or accrued in a trade or business. An individual may claim an itemized deduction for State and local government income and property taxes paid.. Individuals would only be allowed a deduction for State and local taxes paid or accrued in carrying on a trade or business or producing income. The provision would be effective for tax years beginning after December 31, f. Repeal of deduction for personal casualty losses. An individual may claim an itemized deduction for personal casualty losses (i.e., losses not connected with a trade or business or entered into for profit), including property losses arising from fire, storm, shipwreck or other casualty, or from theft.. The deduction for personal casualty losses would be repealed. The provision would be effective for tax years beginning after g. Repeal of deduction for tax preparation expenses : An individual may claim an itemized deduction for tax preparation expenses.. An individual would not be allowed an itemized deduction for tax preparation expenses. The provision would be effective for tax years beginning after h. Repeal of deduction for medical expenses. A taxpayer may claim an itemized deduction for out-of-pocket medical expenses of the taxpayer, a spouse or a dependent to the extent the expenses exceed 10% of the taxpayer s AGI.. The itemized deduction for medical expenses would be repealed. The provision would be effective for tax years beginning after i. Repeal of disqualification of expenses for over-thecounter drugs under certain accounts and arrangements. Expenses incurred for over-the-counter medicine could constitute qualified medical expenses for purposes of receiving tax-favored reimbursements from Health Savings Accounts, Archer MSAs and Health Flexible Spending Arrangements (health accounts) prior to the enactment of section 9003 of the Health Care Act, which limited tax-free disbursements from health accounts to pay for medicine other than prescription medication and insulin. 4 US Tax Reform Alert

5 . The prohibition on using tax-free funds from health accounts to pay for over-the-counter drugs would be repealed, and expenses for such medication could again constitute qualified medical expenses. The provision would be effective for expenses incurred after j. Repeal of deduction for alimony payments and corresponding inclusion in gross income. Alimony payments generally are an-above-the line deduction for the payor and included in the income of the payee.. Alimony payments would not be deductible by the payor or includible in the income of the payee. The provision would be effective for any divorce decree or separation agreement executed after 2014 and to any modification after 2014 of any such instrument executed before such date if expressly provided for by such modification. k. Repeal of deduction for moving expenses. A taxpayer may claim a deduction for moving expenses incurred in connection with starting a new job, regardless of whether or not the taxpayer itemizes his deductions.. The deduction for moving expenses would be repealed. The provision would be effective for tax years beginning after i. Repeal of 2% floor on miscellaneous itemized deductions. Miscellaneous itemized deductions may only be claimed to the extent such deductions in the aggregate exceed 2% of adjusted gross income. The floor applies to all certain itemized deductions. The floor applies after the application of any other limits on such deductions.. The 2% floor on miscellaneous itemized deductions would be repealed. The provision would be effective for tax years after j. Repeal of overall limitation on itemized deductions. The total amount of otherwise allowable itemized deductions (other than certain deductions) is limited for certain upper-income taxpayers. The otherwise allowable total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer s adjusted gross income exceeds a threshold amount. For 2013, the threshold amount is (1) $250,000 for single individuals, (2) $300,000 for married couples filing joint returns and surviving spouses, (3) $275,000 for heads of households and (4) $150,000 for married individuals filing a separate return. The limitation does not reduce itemized deductions by more than 8%. The effect of the limitation is to increase the top marginal rate for individuals by approximately 1.2%.. The overall limitation on itemized deductions would be repealed. The provision would be effective for tax years after k. Fringe benefits. Certain fringe benefits provided by employers to employees are not included in employee income, including no-additional cost services and qualified transportation fringes. No-additional cost services include free air transportation to an employee, retired employee or dependent, spouse or parent of an employee or retired employee or widowed spouse of a deceased employee. A qualified transportation fringe includes, for 2014, up to $250 per month for qualified parking and up to $130 for any transit pass provided by an employer to employees (with these amounts adjusted for inflation). The qualified transportation fringe also includes qualified bicycle commuting reimbursement of up to $20 per month.. The provision would repeal the exclusion from income for air transportation provided as a no additional cost service to the parent of an employee, permanently set the qualified parking amount at $250 per month and the excludable transit pass amount at $130 per month repealing the inflation adjustment of these amounts and repeal the qualified bicycle commuting reimbursement. The provision would be effective for tax years beginning after l. Repeal of exclusion of net unrealized appreciation in employer securities. Distributions from tax-deferred retirement plans generally are subject to tax, including the value of any securities distributed. In the case of a lump-sum distribution of employer securities, however, any net unrealized appreciation in the securities is excluded from income, unless the individual elects to forgo the exclusion. A distributee s basis in distributed employer securities is the securities fair market value, less the unrealized appreciation excluded from gross income, thus preserving any capital gain if the securities are later sold.. The exclusion for net unrealized appreciation in distributed employer securities would be repealed. The distributee generally would have income in the amount of the value of the distributed securities. The provision would be effective for distributions after The repeal of itemized deductions for tax return preparation expenses, and the simplification impact on individuals of the entire proposal, is likely to have a significantly adverse effect on tax return preparers servicing primarily individual clients. The repeal of disqualification of expenses for over-the-counter 5 US Tax Reform Alert

6 drugs as tax-favored distributions from health accounts is likely to benefit the pharmaceutical industry. The repeal of the itemized deduction for state and local income and property taxes is likely to subject states and their political subdivisions to public pressure to reduce those taxes. The current regime permitting itemized deductions for such taxes tends to act as an indirect subsidy transferring tax revenues from the federal government to state and local jurisdictions. PARTNERSHIP TAX I. Repeal of rules related to guaranteed payments and liquidating distributions (Section 3611) Under current law, payments by a partnership to a partner made for services or the use of capital and without regard to the partnership s income are treated as guaranteed payments. Guaranteed payments are generally deductible by a partnership, includible in the recipient s income and are not treated as a distribution of income, capital or as payments made to a partner acting in a capacity other than as a partner. In addition, current law treats partnership payments made in the liquidation of a retiring or deceased partner s partnership interest as either (a) an income share or guaranteed payment or (b) a payment made in exchange for the partner s interest in partnership property. Special rules apply to a deceased partner as to partnership income for the year of death and the basis of the relevant partnership interest in the hands of the successor to the deceased partner. The proposed provision eliminates the concept of guaranteed payments and treats payments to partners as either parts of their shares of partnership income or as received in a non partner capacity (i.e., as an independent contractor). Because of that elimination, partnership payments to a retiring or deceased partner could no longer be treated as guaranteed payments and would be subject to general rules applicable to the payments, such as payments of deferred compensation or subject to the applicable rules relating to income in respect of a decedent. The proposed provision would be effective for tax years beginning in 2014 and to: (a) transfers to decedents made after 2014 and (b) payments in liquidation to partners retiring or dying after The proposed provision may make it more difficult for a partnership to effectively expense payments made to partners, including payments made to retiring or deceased partners. II. Mandatory basis adjustments (Sections 3612 through 3614) Under current law, immediately after a transfer of a partnership interest by a partner or distribution of property to a partner, the partnership is only required to make an adjustment to the basis of partnership property if: (a) the partnership makes a one-election or (b) if the partnership s adjusted basis in its property exceeds fair market value by more than $250,000 (i.e. the partnership has a built-in loss). The adjustments are generally intended to eliminate distinctions that may arise as to a partner s outside partnership basis and share of inside partnership basis as to partnership property. In certain circumstances, certain securitization and investment partnerships may be exempt from the mandatory basis adjustment where there are built in losses. When basis adjustments are currently required in a partnership no corresponding adjustments are currently required in upper-tier or lower-tier partnerships owning an interest in the partnership making the required basis adjustment. Under the proposed provision, mandatory adjustment of a partnership s basis in partnership property would be required after a transfer of a partnership interest by a partner or distribution of property to a partner. These mandatory basis adjustment rules would also apply to securitization and investment partnerships. Moreover, corresponding basis adjustments would be required in in upper-tier or lower-tier partnerships owning an interest in the partnership making the mandatory basis adjustment. The provision would be effective for post-2014 transfers and distributions. The proposed provision may increase accounting costs for partnerships that have transfers of partnership interests or that distribute property to a partner. In addition, the proposed provision may eliminate tax deferral benefits that may have continued to exist from a high partnership property basis that would otherwise not have been reduced but for the mandatory adjustment. 6 US Tax Reform Alert

7 III. Charitable deductions, foreign taxes and partner bases (Section 3615) Under current law, a partner s share of charitable deductions and foreign taxes paid by a partnership may be deducted by the partner even if they exceed the partner s partnership basis. This is in contrast to the general rule that a partner may only deduct the partner s share of partnership expenditures and losses (otherwise deductible to the partner) to the extent of the partner s partnership basis. Under the proposed provision, a partner s share of charitable deductions and foreign taxes paid by a partnership would be taken into account in calculating the partner s basis limitation on deducting the partner s share of partnership losses. To the extent of a partner s share of charitable deductions and foreign taxes paid by a partnership, the proposed provision may decrease the ability of a partner to deduct partnership losses. IV. Unrealized receivables and inventory items (Section 3616) Under current law, gain or loss from a partner s sale or exchange of a partnership interest is generally a capital gain or loss. To the extent of the partner s share of unrealized receivables (unrealized gain inherent in uncollected payments for goods or services) or inventory appreciated by more than 120% ( substantially appreciated inventory ), however, the gain from that sale or exchange is ordinary income. Similar rules may apply in the case of certain distributions to a partner when the partnership holds unrealized receivables or substantially appreciated inventory. The proposed provision eliminates the requirement that inventory be substantially appreciated in order to trigger ordinary income recharacterization on a distribution of the inventory to a partner. In addition, the definition of unrealized receivable is simplified to include any property, other than an inventory item, whose disposition would generate ordinary income if the property were sold for its fair market value. The proposed provision would be effective for distributions and partnership tax years beginning after The proposed provision may increase the likelihood that a partner may have ordinary income from the sale or exchange of partnership interest or as a result of certain distributions to the partner. V. Taxing pre-contribution gain (Section 3617) Under current law, if a partner contributes appreciated property to a partnership, there is no gain or loss on the contribution. Instead, the pre-contribution gain or loss is preserved in the capital account of the partner. Distribution of the appreciated property to another partner with in seven years of the contribution (the limitation period), triggers the pre-contribution gain or loss that was preserved in the contributing partner s capital account. Similar rules apply if other partnership property is distributed to the contributing partner within the limitation period. The proposed provision eliminates the limitation period exception effective for property contributed to a partnership after The proposed provision eliminates the ability of partners to use a partnership to engage in what results in a disguised sale of property by a contributing partner. VI. Partnership interests created by gift (Section 3618) Under current law, for purposes of the family partnership provisions, a person is treated as a partner if the person owns a capital interest in a partnership in which capital is a material income producing factor, whether the interest was acquired by purchase or gift from another person. The proposed provision clarifies that another person may include a family member (i.e. a spouse, ancestor, lineal descendants and any trusts for the primary benefit of such persons). The provision would be effective for tax years beginning after Since the proposed provision is a clarification, it may not have a significant effect on taxpayers participating in family partnerships. 7 US Tax Reform Alert

8 VII. Repeal of technical termination (Section 3619) Under current law a partnership terminates for income tax purposes if: (a) no part of its business, financial operation or venture continues to be carried by on by any of its partners in a partnership or (b) within a 12-month period there is a sale or exchange of 50% or more of the total interest in partnership capital and profits (a technical termination). When a technical termination occurs, although the legal form of the partnership continues, the partnership is often forced to make new tax elections, including for depreciation lives and other purposes. The proposed provision eliminates the technical termination rule effective for tax years beginning after Repeal of the technical termination rule may save accounting costs incurred in making new tax elections for a continuing partnership business that would have had a technical termination under current law. In other cases, where new tax elections would be advantageous, repeal of the technical termination rule would prevent those new elections from being made without the approval of the IRS. VIII. Publicly traded partnership restriction (Section 3620) Under current law a partnership whose partnership interests are traded on an established securities market or are readily traded on a secondary market (publicly traded partnership) is generally treated as a C corporation. An exception as to that C corporation treatment applies in the case of a publicly traded partnership (other than a regulated investment company described in Internal Revenue Code Section 851(a)) if 90% or more of the partnership s gross income is qualifying income, such as interest, dividends, capital gains, rents from real property and certain minerals or natural resources activities. Under the proposed provision, only Publicly Traded Partnerships with 90% or more of their gross income from certain minerals or natural resources activities would qualify for the exception from C corporation treatment. The proposed provision would be effective for tax years beginning after The proposed provision will cause publicly traded partnerships that do not have 90% or more of their gross income from certain minerals or natural resources activities to be treated as C corporations. IX. Recharacterization of capital gains of certain service partners into ordinary income (Section 3621) Under current law a partner s share of a partnership s income generally has the same character as that of the partnership. Thus for example, a general partner managing a partnership holding only stock or securities would have a share of the partnership s capital gain from the disposition of that stock or securities. Similarly, if the general partner disposed of the partner s partnership interest in that partnership, the general partner would generally have capital gain or loss from that disposition. The proposed provision would change current law as to an applicable partnership interest. An applicable partnership interest would include any interest transferred, directly or indirectly, to a partner in connection with the performance of services if the partnership s trade or business conducted on a regular, continuous and substantial basis consist of: (a) raising of returning capital, (b) identifying, investing in or disposing of other trades or businesses and (c developing such trades or businesses. The provision would not apply to a partnership engaged in a real estate trade or business. The proposed provision has a recharacterization formula whereby the service partner s applicable share of the partnership s invested capital (based on contribution amount and value, including loans to the partnership and debt entitled to share in partnership equity) would be treated as generating ordinary income by multiplying that applicable share by a specified rate of return (the federal long-term interest rate plus 10 percentage points). This formula is intended to approximate the compensation earned by the service partner for managing partnership capital. The recharacterization amount would be determined annually (but not realized) and tracked over time in a recharacterization account. On a distribution by the partnership to the service partner or a realization event to the service partner (such as a disposition of his partnership interest), the gain to the service partner would be treated as ordinary to the extent of the partner s recharacterization account balance for the tax year. Amounts in excess of the recharacterization account balance would be treated as capital gain. All applicable partnership interests held (directly or indirectly) by a service partner in a partnership would be aggregated and treated as a single interest. The proposed provision would be effective for tax years beginning after US Tax Reform Alert

9 If a partnership has applicable partnership interests, the proposed provision may create significant: (a) additional income tax liability for the service partners holding applicable interests and (b) accounting costs to: (i) keep track of the recharacterization account balances of the service partners holding those applicable interests and (ii) calculate the recharacterization as ordinary income of what, but for the proposed provision, would otherwise be capital gain to a service partner. X. Partnership audits and adjustments (Section 3622) Under current law, there are different audit regimes for auditing different sized partnerships. For partnerships with 10 or less partners, the IRS generally audits the partnership and the partners separately. For most partnerships with more than 10 partners, the IRS generally conducts the audit at the partnership level under so-called TEFRA rules and, once the audit is complete for an audit year, the IRS calculates the adjustments for each partner for that audit year. Partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (ELPs) are under a separate audit regime where IRS adjustments flow through to the partners for the year of adjustment rather than the year of audit. Under the new provision, the TEFRA and ELP rules would be repealed and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners. Any adjustments would be taken into account by partners in the adjustment year i.e. the year that the audit or relevant judicial review is complete. A partnership would also have the option of initiating an adjustment for a reviewed year. Partnerships with less than 100 partners would be able to opt out of the new rules and be audited under the general rules applicable to individual partners. The impact on clients will depend on the size of the partnerships in which they participate and alternatives elected by those partnerships. CORPORATE INCOME TAXES I. General provisions a. Repeal of Alternative Minimum Tax (Section 2001) Taxpayers must compute their income for purposes of both regular income tax and the alternative minimum tax (AMT), and their tax liability is equal to the greater of their regular income tax liability or AMT liability. Alternative minimum taxable income (AMTI) represents a broader base of income than regular taxable income. AMT credits may be carried forward and claimed against regular tax liability in any future tax year to the extent such liability exceeds AMT. The AMT is repealed effective for tax years beginning after If a taxpayer has AMT credit carryforwards, the taxpayer would be able to claim a refund of 50% of the remaining credits (to the extent credits exceed regular tax for the year) in the tax years beginning in 2016, 2017 and A refund for all remaining credits may be claimed in The requirement to compute two tax liabilities is among the most burdensome complexities of the current Internal Revenue Code, and the repeal of the AMT should save taxpayers time and resources because of the elimination of the second tax computation. b. The 25% corporate tax rate (Section 3001) The highest marginal corporate income tax rate is 35%. Personal services corporations are not entitled to use the graduated corporate rates below the 35% rate. The proposal provides for a flat corporate income tax rate of 25% beginning in Taxable income up to $75,000 will be subject to this 25% rate in 2015, with the rate on income above that level phased down to 25% during the years Further, the special rule applicable to personal services corporations would be repealed effective for tax years beginning after The current corporate tax rates are among the highest in the industrialized world that many have argued puts American companies at a competitive disadvantage with their non-us counterparts. Because this provision is anticipated to reduce revenues, it is likely that various deductions companies have traditionally relied upon will be repealed or modified, as evidenced by other provisions included in the Proposal. II. Reform of exclusions and deductions a. Reform of accelerated cost recovery system (Section 3104) Under current law, certain property used in a trade or business or for the production of income is subject to depreciation under the modified accelerated cost recovery system (MACRS). Under MACRS, the 200% or 150% 9 US Tax Reform Alert

10 declining balance methods are generally applicable with respect to tangible personal property, generating larger depreciation deductions in the early years than would the straight-line method, until the tax year in which the straight line method would produce a larger deduction, at which point the straight-line method is used. Certain special depreciation provisions enacted over the last several years have also accelerated cost recovery for certain assets, such as 50% or 100% bonus depreciation for certain property placed in service from 2008 through The proposal would repeal MACRS and replace it with a system substantially similar to the alternative depreciation system (ADS) that currently applies under certain circumstances, such as with respect to corporate taxpayers subject to AMT. Under the proposal, depreciation deductions would be determined under the straight line method, and the depreciation period with respect to certain asset classes would be lengthened. The proposal would permit taxpayers to elect to take an additional depreciation deduction to account for the effects of inflation on depreciable property, based on the chained CPI rate for the year. The proposal would require the Treasury Department, in consultation with the Bureau of Economic Analysis, to develop a new depreciation schedule to more closely reflect the useful lives of assets and submit a report to Congress by December 31, The new provisions would apply with respect to property placed in service after In addition to repealing MACRS, the proposal would also repeal a number of special depreciation provisions, including bonus depreciation, and the 15-year depreciation applicable to qualified leasehold improvements. The proposal would generally serve to reduce the magnitude of a taxpayer s annual depreciation deductions, primarily in the early years after an item of depreciable property is placed in service, thereby increasing the taxpayer s annual taxable income in those years. Although the aggregate depreciation deductions would remain the same, on a present value basis, the value of the depreciation deductions would be reduced. The proposal would have the greatest impact on capital intensive industries that invest heavily in depreciable assets. b. Amortization of certain advertising expenses ( 3110) Although not addressed specifically in the Internal Revenue Code, the IRS generally allows taxpayers to treat advertising expenditures as an ordinary and necessary business expense. Additionally, with regard to amounts paid to develop a package design even those whose useful life is beyond the current taxable year such amounts are deductible as costs in the year incurred. Certain advertising expenses would be currently deductible at a 50% rate, and the other 50% would be amortized ratably over a ten-year period. This rule would phase in for tax years beginning until 2018, when the 50/50 treatment would apply. The proposal would also permit taxpayers to expense the first $1 million of advertising expenditures. However, the $1 million would be reduced to the extent a taxpayer s advertising costs exceed $1.5 million and completely phase out once advertising costs exceed $2 million. This provision would be effective for amounts paid or incurred in tax years beginning after The proposal defines advertising expenses to include any amount paid or incurred for development, production or placement of any communication to the general public intended to promote the taxpayer s trade or business. Such expenses would also include wages paid to employees who primarily engage in activities related to advertising. Advertising expenses would not include: depreciable property, amortizable section 197 intangibles, discounts, certain communications on the taxpayer s property, the creation of logos and trade names, marketing research, business meals and qualified sponsorship payments. Finally, amounts paid to develop a package design will be capitalized into the cost of producing the packaging and recovered as the packaging is sold. Many US companies spend a significant amount of capital on marketing and advertising, and many of those expenses, including the wages of employees focused on marketing and advertising, have generally been currently deductible when calculating net taxable income. Although the proposed legislation calls for a lower corporate income tax rate, the net effect may be increased tax cost given the limitation on the current deductibility of certain advertising expenses. c. Phaseout and repeal of domestic production deduction (Section 3122) Under current law, subject to certain limitations, taxpayers may claim a deduction equal to 9% (or 6% as to certain oil and gas activities) of the lesser of the taxpayer s taxable income or the taxpayer s qualified production activities income for the applicable tax year. Qualified production activities income is equal to the excess of certain gross receipts derived from property manufactured, produced, grown or extracted within the United States, certain film productions, production of electricity, natural gas or 10 US Tax Reform Alert

11 drinking water, construction activities performed within the United States and certain engineering or architectural services, over the costs thereof and expenses properly allocable to such gross receipts. The proposal would phase out the deduction over two years (6% for tax years beginning in 2015 and 3% for tax years beginning in 2016) and would eliminate the deduction for tax years beginning after The proposal would reduce and eventually eliminate the special deduction currently available with respect to the types of activities described above. The wide variety of taxpayers engaged in the specified activities would face a higher tax burden as a result of the elimination of the special deduction. d. Prevention of arbitrage of deductible interest expense and tax-exempt interest income ( 3124) Taxpayers may not deduct interest on indebtedness incurred to purchase or carry obligations if the interest income from the obligations is exempt from tax (IRC 265). The rule is intended to prevent taxpayers from engaging in tax arbitrage by deducting interest on indebtedness used to purchase tax-exempt obligations. There are two methods for determining the amount of the disallowance: one that applies to all taxpayers other than financial institution and dealers in tax-exempt obligations, and one that applies to financial institutions and dealers in exempt obligations. The second method includes a special rule that excludes certain qualified small issuer tax-exempt obligations from the pro rata disallowance rule. Additionally, individuals may not deduct investment interest in excess of net investment income, although such disallowed investment interest deductions may be carried over to the succeeding tax year. All C corporations would be required to use the same interestdisallowance method. Thus, the interest deduction of any taxpayer would be disallowed based on the percentage of the taxpayer s assets comprised of tax-exempt obligations. The special rule under present law for qualified small issuer tax-exempt obligations also would be repealed. In addition, a taxpayer s investment interest deduction (other than a corporation or financial institution) would be permanently disallowed by the amount of tax-exempt interest received. Any remaining interest deduction would still be limited to the taxpayer s net investment income. The provision relating to the interest-disallowance method would be effective for tax years ending after and obligations issued after February 26, The provision relating to the investment-interest deduction would be effective for tax years beginning after This provision will potentially increase the tax cost of those taxpayers who are subject to the method that inquires whether their borrowing can be traced to their holding of taxexempt obligations and those taxpayers who are subject to the second method and whose portfolio includes a significant amount of qualified small issuer tax-exempt obligations. e. Research credit modified and made permanent (Section 3203) Under current law, a taxpayer could claim a credit for qualified US-based research expenses prior to The research credit had three components: A taxpayer could claim a credit equal to 20% of the amount by which the taxpayer s qualified research expenses for a tax year exceeded its base amount for that tax year. An alternative, simplified research credit (ASC) could be claimed in lieu of the above basic credit in an amount generally equal to 14% of the qualified research expenses for the tax year that exceeded 50% of the average qualified research expenses for the prior three tax years. A taxpayer could claim a 20% credit for certain amounts paid to universities and certain non-profit scientific research organizations for basic research. A taxpayer could claim a 20% credit for certain amounts paid to energy research consortiums for research conducted by such organizations. Deductions otherwise allowed to a taxpayer with respect to its research expenses were reduced by the amount of the research credit for the tax year. A taxpayer could alternatively elect to claim a reduced research credit in lieu of reducing its otherwise allowable deductions. The proposal would make permanent a modified version of the research credit. The new research credit would generally equal the ASC portion of the prior research credit (though utilizing 15%, rather than 14%, of qualified research expenses for the tax year in excess of 50% of the average qualified research expenses for the three prior tax years), plus 15% of the basic research payments made for the tax year that exceed 50% of the average basic research payments made for the three prior tax years. The prior 20% credit for qualified research expenses, 20% credit for amounts paid to certain organizations for basic research, and 20% credit for amounts paid to an energy research consortium would be repealed. The proposal would also repeal the election to claim a reduced research credit in lieu of reducing otherwise allowed deductions. 11 US Tax Reform Alert