TAX BULLETIN 2017-7 DECEMBER 6, 2017 0BSENATE AND HOUSE PASS SEPARATE TAX BILLS: 1BTAX REFORM ON THE HORIZON OVERVIEW Following on the heels of the House s passage of a tax reform bill, the Senate passed a structurally similar bill, but with several material differences, such as the January 1, 2018 repeal of the Affordable Care Act s individual mandate (the penalty for failing to maintain minimum essential health care coverage). In Tax Bulletin 2017-5 we summarized the key parts of the individual, wealth transfer and corporate tax provisions in HR1, known as the Tax Cuts and Jobs Act (the House Bill ), which was passed (227-205) by the House on November 16, 2017. In Tax Bulletin 2017-6 we summarized and compared key parts of the provisions in the initial Senate bill HR1, also known as the Tax Cuts and Jobs Act (the Senate Bill ), which was subsequently amended and passed (51-49) by the full Senate on December 2, 2017. From the introduction of the Senate s tax bill to its final passage, a number of changes were made. Specifically, in order to abide by Senate budget reconciliation rules and ensure its version does not result in budget deficits outside the 10-year budget window, the Senate Bill makes almost all individual income tax provisions temporary nearly all expire at the end of 2025. On the other hand, most corporate provisions are permanent. This Tax Bulletin 2017-7 updates the tax reform status as the two bills head to a joint compromise committee to be reconciled into a single bill to be voted on by both chambers. We believe a joint version will result, and the odds are high that it could become law by year s end. While it may be too early to take certain actions, taxpayers may want to consider the implications of typical year-end decisions, such as selling capital assets and charitable giving, but await more clarity before taking action. INDIVIDUAL TAXES 1 Current Law0F 2 House Bill1F 3 Senate Bill2F Individual Tax Rates Standard Deduction Kiddie Tax 10, 15, 25, 28, 33, 35, 39.6% 12, 25, 35, 39.6%; phase-out of 12% bracket for high-income taxpayers Top rate would apply to income over $1 million for married filing jointly; $500,000 for single 10, 12, 22, 24, 32, 35, 38.5% Top rate would apply to income over $1 million for married filing jointly; $500,000 4 for single 3F $12,700 ($6,350 if single) $24,400 ($12,200 if single) $24,000 ($12,000 if single), enhanced for elderly and blind 4 Unearned income of a child taxed at parents tax rate if higher than child s rate Simplifies kiddie tax by applying trust rates to unearned income of a child Simplifies kiddie tax by applying trust rates to unearned income of a child Personal Exemption Top Capital Gains/Dividend Tax Rate $4,050, subject to phase-out Eliminates; merged with higher standard deduction 20% (plus 3.8% surtax) Current maximum rate is retained; same breakpoints as current law Eliminates; merged with higher standard deduction 4 Current maximum rate is retained; same breakpoints as current law 4
INDIVIDUAL TAXES (continued) Current Law House Bill Senate Bill Itemized Deductions Under the Pease limitation, up to 80% of most itemized deductions are lost when adjusted gross income exceeds $313,800 ($261,500 for single taxpayers) Repeals the Pease limitation on itemized deductions Mortgage interest deduction: reduced from $1 million acquisition indebtedness to $500,000, limited to principal residence; deduction for home equity loan repealed Repeals deduction for state and local income or sales tax; real property taxes limited to $10,000; deduction allowed for state and local taxes on trade or business Repeals deduction for medical expenses Repeals the Pease limitation on itemized deductions Mortgage interest deduction: $1 million limit on acquisition indebtedness retained; deduction for home equity loan repealed Repeals deduction for state and local income or sales tax; real property taxes limited to $10,000; deduction allowed for state and local taxes on trade or business Deduction for medical expenses retained and liberalized for 2017 and 2018 4 Retirement Savings Contributions can be placed into deferred account, up to contribution cap Unchanged Unchanged AMT Parallel tax calculation with top rate of 28% Eliminates AMT Retains and modifies AMT; exemptions raised 4 Carried Interest Retains character as capital gain and eligible for preferential tax rates Requires three-year holding period to attain long-term capital gains rate Requires three-year holding period to attain long-term capital gains rate Investment Surtax 3.8% tax on net investment income Unchanged Unchanged OBSERVATIONS INDIVIDUAL TAXES Under the House and Senate Bills, there will be winners and losers on the personal income tax side. Generally, wage earners from no-tax states4f5 could see tax savings under both Bills. For instance, a Florida taxpayer earning $1 million with moderate itemized deductions may see a tax savings of about $27,500 under the House Bill and about $26,000 under the Senate Bill. A similar taxpayer in New York State may see almost no change under the House Bill and a savings of about $12,000 under the Senate Bill, according to our preliminary analysis.5f6 Conversely, very high-wage earners from high-tax states could see a higher tax bill. A taxpayer earning $3 million in New York State may see a significant tax increase: $76,000 under the House Bill and $19,000 under the Senate Bill, due in part to the loss of significant deductions (and, with respect to the House Bill, a surtax from the phaseout of the lowest tax bracket). A similar taxpayer in Florida would see a tax savings of about $38,000 under the House Bill and about $70,000 under the Senate Bill (primarily due to the lower tax brackets and regaining itemized deductions that are no longer phased-out), according to our preliminary analysis.6f7 2
It appears that state of residence, type of income (wages versus new qualified business income ), and home ownership will be among the most important factors for determining whether one is better or worse off under the House Bill. WEALTH TRANSFER TAXES Current Law House Bill Senate Bill Estate Tax 40% rate, $5,490,000 exemption (indexed for inflation) Commencing 2018, exemption for estate tax doubled from $5.6 million to $11.2 million (indexed for inflation) Commencing 2018, exemption for estate tax doubled from $5.6 million to $11.2 million (indexed for inflation) Beginning in 2025, estate tax repealed Enhanced exemption expires end of 2025 Gift/GST Tax 40% rate, $5,490,000 exemption (indexed for inflation) Commencing 2018, exemption for gift and GST tax doubled from $5.6 million to $11.2 million (indexed for inflation) Beginning in 2025, GST tax repealed and gift tax lowered to 35% with $11.2 million (indexed) exemption Commencing 2018, exemption for gift and GST tax doubled from $5.6 million to $11.2 million (indexed for inflation) Enhanced exemption expires end of 2025 Tax Basis Upon Death Step-up for estate property Same as current; step-up for estate property, even after estate tax repeal Same as current; step-up for estate property OBSERVATIONS WEALTH TRANSFER The transfer tax proposals in the House Bill would represent a dramatic change to our transfer tax system. As indicated, there would be a doubling of the exemptions until 2025, at which time there would be estate and GST tax repeal. The gift tax would remain. The step-up in basis at death would continue, both before and after the estate tax repeal. The transfer tax proposals in the Senate Bill would also double the exemption, but would not repeal the tax and would be temporary (reverting to current law in 2026). We expect a unified bill would adopt the Senate provisions. Given the high exemption amounts ($11.2 million for individuals and $22.4 million for a married couple), that would effectively repeal the tax for most people. These proposals would have a significant effect on both testamentary and lifetime estate planning. Testamentary planning. Given the uncertainty of whether the estate tax would be effective or repealed at a person s death, it may be advisable for wills and other testamentary documents (such as revocable trusts) to contain alternate provisions. Documents could provide for one set of dispositions in case the estate tax is in effect and another set in case there is estate tax repeal. As always, documents should be drafted with flexible provisions that can be adjusted for future changes. If the estate tax is repealed, repeal may only be temporary. That is, even if estate tax repeal is permanent, the estate tax could always be reinstated by future legislation. Lifetime planning. Lifetime gifts are often made in order to reduce the estate tax that would otherwise be incurred at death. This analysis should also take into account any capital gains tax, if assets are sold. This analysis can be done if you can reasonably determine what the estate tax and basis step-up rules would be at death. Since there is uncertainty whether the estate tax will be imposed at a person s death, either due to actual repeal or due to an increase in the exemption, the tax consequences of making a current gift may have to be compared with 3
alternative estate tax scenarios, including: (1) estate tax and basis step-up, as under current law and also under the Senate Bill for individuals with estates in excess of the exemption; and (2) estate tax repeal and basis step-up, as under the House Bill and also the Senate Bill for individuals with estates covered by the exemption. This will make planning more challenging because you are comparing multiple scenarios, and there may be inconsistency as to which strategy achieves the best result. CORPORATE TAXES Current Law House Bill Senate Bill Top C-Corporate Rate AMT Business Investments 35% 20% (personal service corporations subject to a 25% rate) and effective 2018 Parallel tax calculation with top rate of 20% Limited immediate expensing; balance subject to depreciation Eliminates AMT Immediate expensing for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (with additional year for certain property) 20% and effective 2019; there does not appear to be a higher rate for personal service corporations Retains AMT Immediate expensing for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (with partial expensing for property acquired after 2022 and before 2026) Interest Expense No limitation Limited to business interest income, plus 30% of a business s adjusted taxable income (EBITDA), with an exception for floor plan financing indebtedness ; full deduction for small businesses with gross receipts of $25 million or less Limited to business interest income, plus 30% of a business s adjusted taxable income (EBIT); with special rules for floor plan financing indebtedness ; full deduction for small businesses with gross receipts of $15 million or less 4
PASS-THROUGH ENTITY TAXES Current Law House Bill (HR 1) Senate Bill Top Rate: Pass-Through Entities (S-corporations, LLCs, LLPs and Partnerships) /Sole Proprietorships Subject to tax at individual rates up to 39.6% 25% rate for portion of net income treated as qualified business income. For passive owners, that would generally be all business income. For active owners, generally 30% of net business income derived from active business activities, with remaining 70% subject to ordinary individual rates; May elect to apply formula to determine percentage greater than 30% for capital-intensive business; Special 9% rate for some passthrough income, in lieu of the 12% rate, and would apply to the first $75,000 of net business taxable income of an active owner or shareholder earning less than $150,000 in taxable income through a pass-through business. The benefit of the 9% rate phases out for income above $150,000 and would be fully phased-out at $225,000. The 9% rate is phased in over five years An individual taxpayer generally may deduct 23% of domestic qualified business income from a partnership, S corporation, or sole proprietorship 4 In the case of a taxpayer who has qualified business income from a partnership, S corporation or sole proprietorship, the amount of the deduction is limited to 50 percent of the W-2 wages Does not apply to trusts and estates Pass-Through Entities Service Businesses Subject to tax at individual rates up to 39.6% Portion of net income treated as qualified business income, for service business (e.g., accounting, law, consulting, investing, etc.) generally 0%; May elect to apply formula to determine a percentage greater than 0% for capital-intensive service business, provided minimum capital is at least 10% 23% deduction does not apply to specified service businesses, except in the case of a taxpayer whose taxable income does not exceed $600,000 (for married individuals filing jointly; $300,000 for other individuals); benefit of the deduction for service providers begins being phased out for taxable income exceeding $500,000 (for married individuals filing jointly; $250,000 for other individuals); wage limitation not applicable for taxpayers with taxable income below these amounts 4 5
OBSERVATIONS PASS-THROUGH ENTITIES House Bill. The House Bill fundamentally changes the taxation of many pass-through entities (sole proprietorships, partnerships, LLCs, LLPs and S-corporations) by allowing qualified business income to be taxed at a preferential rate of 25%. Originally, this provided no benefit for married taxpayers with taxable income below $260,000 (or single taxpayers below $200,000) because they would already be in a bracket lower than 25% for 2018. The House bill was modified, and a special 9% bracket was introduced for lower income taxpayers (other than estates and trusts). Taxpayers who are passive owners in a business would be eligible for the 25% rate on all their business income. However, taxpayers who are active owners would be eligible for the 25% rate on only a portion of their business income (generally 30%, but perhaps greater if the business is capital intensive). While upper-income wage earners in hightax states generally do not fare well under the House Bill, taxpayers with substantial income from passthrough businesses should see a tax benefit compared with current law, since the weighted average rate of business income would be approximately 35%7F8. Capital gains, dividends, and other preferential income from a business would not be considered business income and would continue to be taxed at preferential tax rates. Owners of service businesses (e.g., law, accounting, consulting, etc.) generally would not be eligible for the 25% rate, unless at least 10% of their business income is derived from capital (as determined by proposed tax rules), and then only to such extent. Senate Bill. The Senate Bill approaches small business relief from a very different angle and has a host of complex limitations. Rather than a fixed reduced rate, a 23% deduction is allowed; the reduced amount would then be subject to normal marginal tax rates. Therefore, the top tax rate for business income would be 29.65% ((100% - 23% = 77%) x 38.5% = 29.65%). For taxpayers not in the top income tax bracket, the value of the deduction will depend on the marginal bracket that would otherwise be imposed on the income. In addition, instead of limiting this benefit to 30% of business income (as the House Bill does), it limits it to 50% of wages, with an exception for businesses with moderate income (as noted below). Owners of service businesses (e.g., law, accounting, consulting, etc.) generally would be eligible for the 23% deduction unless income exceeds $600,000 for married filing jointly ($300,000 for others). At $500,000 and $250,000, respectively, the benefit begins being phased out and fully eliminated out over the next $100,000 for married filing jointly ($50,000 for others). It is important to note that the pass-through deduction does not apply to businesses held in estates or trusts. Accordingly, taxpayers should consider the consequences of such ownership limitations when planning transfers of family businesses into trusts or the benefits of transfers out of trusts to individual beneficiaries. 6
CORPORATE INTERNATIONAL TAXES Current Law House Bill (HR 1) Senate bill International Corporate Tax Scope Worldwide with deferral available 100% of foreign-source portion of dividends paid by foreign corporation to U.S. corporate shareholder (that owns at least 10%) would be exempt from U.S. taxation 100% of foreign-source portion of dividends paid by foreign corporation to U.S. corporate shareholder (that owns at least 10%) would be exempt from U.S. taxation One-Time Deemed Repatriation of Foreign Earnings No U.S. shareholders owning at least 10% of a foreign corporation would be taxed on post-1986 net foreign earnings and profits (14% on earnings and profits comprising cash or cash equivalents; 7% on remaining earnings and profits); may elect to pay tax over a period of up to 8 years, in equal annual installments U.S. shareholders owning at least 10% of a foreign corporation would be taxed on post-1986 net foreign earnings and profits (14.49% on earnings and profits comprising cash or cash equivalents; 7.49% on remaining earnings and profits); may elect to pay tax over a period of up to 8 years, in annual installments that allow more to be paid at the back end OTHER PROVISIONS There are other provisions of note that are not included in the charts above. Roth recharacterization no longer allowed. Under current law, if you convert a traditional IRA to a Roth IRA, you can recharacterize that conversion within certain time limits, in effect undoing it. o For tax years beginning after 2017, the House and the Senate Bill repeal this rule, meaning you can no longer recharacterize a Roth conversion. From the current language of the effective date, it is unclear whether this would prevent a 2017 Roth conversion that has already occurred from being recharacterized in 2018. Sale of principal residence exclusion. Under current law, up to $250,000 of gain ($500,000 if filing jointly) on the sale of a principal residence may not be taxed. Among the requirements is that the principal residence be owned and used as your principal residence for two out of the last five years. You can use this rule only once every two years. This exemption is available regardless of income. o House Bill. For sales after 2017, the House Bill makes three changes. First, the principal residence must be owned and used as your principal residence for five out of the last eight years. Second, you can use this rule only once every five years. Third, the amount of gain that can be excluded is phased out dollar for dollar for average modified AGI over $250,000 ($500,000 for joint filers) for the taxable year and two preceding taxable years. For joint filers, this means that if average modified AGI is $1,000,000, the exclusion is fully phased out and would not be available. o Senate Bill. The Senate Bill contains the first two changes noted above; it does not contain a phase-out based on AGI. 7
Identification of Securities Sold, Exchanged and Gifted. Under current law, gain or loss generally is recognized for Federal income tax purposes on the sale of property. A taxpayer s gain or loss on a disposition of property is the difference between the amount realized on the sale and the taxpayer s cost basis in the property disposed of. If a taxpayer has acquired stock in a corporation on different dates or at different prices and sells or transfers some of the shares of that stock, and the lot from which the stock is sold or transferred is not adequately identified, the shares sold are deemed to be drawn from the earliest acquired shares (the first-in-first-out rule ; FIFO). However, if a taxpayer specifically identifies the shares of stock to be sold, the shares of stock treated as sold are the shares that have been identified. The same rules apply to charitable gifts and gifts to trusts or family members. o House Bill. The House Bill does not propose any changes to the specific identification rules. o Senate Bill. The Senate proposal requires that the cost basis of any specified security sold, exchanged or otherwise disposed of on or after January 1, 2018, be determined on a first-in first-out basis. Thus, any sale a taxpayer makes will come from shares first acquired (whether that is high or low basis). And, any charitable gift a taxpayer makes will also come from shares first acquired (whether high or low basis). While the charitable deduction will generally equal the fair market value of the shares, a taxpayer generally wants shares given to charity to have the lowest tax basis (in which case the proposed rule could be beneficial assuming the first acquired shares are the lowest basis shares). However, in the case of sales, the proposed rule might result in maximizing taxable gain. o Under current regulations, absent specific identification, the default FIFO rule would apply to the particular account when the shares are sold. For example, assume you have one lot of high basis XYZ stock at Firm 1 and another lot of low basis XYZ shares at Firm 2: two separate accounts. If you instruct Firm 1 to sell shares and do not specifically identify the lot to be sold, the current default FIFO rule would not say that the low basis shares at Firm 2 have been deemed sold. Rather, the current default FIFO rule applies on an account-by-account basis, and in this example the only shares at Firm 1 were high basis shares; that s what s deemed sold. Under current regulations, to avoid the potentially harsh effect of the proposed mandatory FIFO rule, an account could be set up at a particular organization to hold the specific high basis lot of XYZ shares, then another account to hold the specific low basis lot of XYZ. You could then potentially navigate around the FIFO rule by simply identifying which account to sell/gift from. Currently, brokers and asset managers have some flexibility on how they report tax information to clients when clients have multiple accounts. If the Senate provision becomes law, it remains to be seen if the current regulations will be revised to tighten the rules and inhibit clients from having multiple accounts at the same organization in order to segregate tax lots of a single issuer. Like-kind exchanges. Currently real estate and personal property can qualify for a tax-deferred likekind exchange. The property must be held either for investment or for use in a trade or business. o House Bill. Under the House Bill, like-kind exchanges will be available only for real estate, not personal property. This will end, for example, like-kind exchanges of art. This new rule is effective for transfers after 2017. However, there is a transition rule to allow like-kind 8
exchanges of personal property to be completed if you have either disposed of the relinquished property or acquired the replacement property on or before December 31, 2017. o Senate Bill. The Senate Bill contains a similar provision. 529 Savings Plans. Currently, funds in 529 Saving Plans can be withdrawn tax-free if used for higher education expenses. o House Bill. Under the House Bill, up to $10,000 per year could be used for elementary and high school tuition. o Senate Bill. The Senate Bill also allows up to $10,000 per year used for elementary and high school tuition but goes further by specifically allowing funds to be used for private (including home schooling) and religious schools. Charitable Gifts. A charitable contribution deduction is currently limited to a certain percentage of the individual s adjusted gross income (AGI), and this limitation varies depending on the type of property contributed and the type of exempt organization receiving the property. In general, 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. o House Bill. Under the House Bill, this 50% limitation would be increased to 60%. The provision would retain the 5-year carryover period to the extent that the contribution amount exceeds 60% of the donor s AGI. o Senate Bill. The Senate Bill contains a similar provision. Investment Expenses and Investment Interest. CONCLUSION o House Bill. Without any explanation, the House Bill retains itemized deductions for investment interest expenses and investment expenses. Under current law, investment expenses are deductible as a miscellaneous itemized deduction if, and to the extent, they exceed 2% of AGI. Under current law, these miscellaneous itemized deductions are not deductible for purposes of the alternative minimum tax (AMT). If the AMT is repealed, this expense could be more meaningful for upper-income taxpayers. The deduction for investment interest also remains untouched and, as under current law, would be limited to investment income. o Senate Bill. The Senate Bill repeals the deduction for miscellaneous itemized deductions that are subject to the 2% AGI limitation, such as investment management expenses. Other itemized deductions that are not subject to the 2% AGI limitation remain deductible, such as investment interest expense. Now that both chambers have a final version approved by its members, the two versions will have to be reconciled by a joint committee. The House and Senate Bills are structurally similar, and reconciling the two should not be a major hurdle. House and Senate conference committee members can pick between provisions included in one bill but not the other (such as changes to medical expense deductibility), compromise between different modifications contained in each bill (such as to mortgage interest deduction) or in other instances determine among different methodologies for taxing income from pass-through businesses (such as a deduction 9
or a lower tax rate). It is anticipated that the joint committee will look to complete its work by December 15. That will allow the House to vote on a unified bill the week of December 18 and send it to the Senate for passage by December 22. This will take place with a backdrop of a potential government shutdown, which can sidetrack Congress and delay the process. However, it appears that we could see major tax reform by year end. Given the significant tax changes anticipated for next year, year-end planning will be especially difficult. While it is always best to plan based on actual law rather than proposals, it is also wise to understand the implications that various House and Senate proposals can have on your particular tax situation. National Wealth Planning Strategies 1 Inflation-adjusted amounts for 2017. 2 Tax Cuts and Jobs Act (HR 1), dated November 16, 2017. 3 Tax Cuts and Jobs Act (HR 1) as amended by the Senate dated December 2, 2017. 4 This proposed change would be effective starting in 2018 and would sunset at the beginning of 2026. 5 There are nine states that impose no state income tax: AK, FL, NH, NV, SD, TN, TX, WA and WY (NH and TN impose a tax only on dividends and interest). 6 This illustration assumes the following itemized expenses: charitable gifts $10,000, real estate tax $30,000 (limited to $10,000 under the proposal), mortgage interest of $15,000, and appropriate state income taxes, where applicable. 7 A surtax on high-income taxpayers would be imposed by phasing out the lowest (12%) tax bracket. This would result in an additional 6% tax on income between $1,200,000 and $1,614,000 for married taxpayers, resulting in additional tax of up to $24,840. A similar rule applies to single taxpayers at different thresholds. 8 At least 30% of the business income would be taxed at a favorable 25% rate, and 70% of the business income would be taxed at rates up to 39.6%, resulting in a weighted average rate of about 35% (assuming the benefit of the 9% bracket has been fully phased out). IMPORTANT: This publication is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy are dependent upon your individual facts and circumstances. Clients should always consult with their independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. Clients should consult with their legal and/or tax advisors before making any financial decisions. U.S. Trust operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. 2017 Bank of America Corporation. All rights reserved. NWPSSenateBill December 2017 10