At a Glance
The Tax Cuts and Jobs Act (TCJA) has been through the Conference Committee, passed by the House and Senate, and was signed by President Trump on Friday, December 22, 2017. (Due to parliamentarian rules, the bill’s official title is much longer and unwieldy.) Changes to the tax code described in this bill will affect nearly every taxpayer and include significant developments related to individual, business, and international tax regulations.
Highlights of the Bill
Individual Tax Reform
The final bill departs from the original House bill in several significant areas. Importantly, all individual tax provisions under the Conference bill expire after 2025, which is necessary in order to keep the bill compliant with budget reconciliation rules. Key individual tax reform items include:
New Rate Brackets:
In a departure from the House version of the bill, which reduced the number of rate brackets from seven to four (12%, 25%, 35%, and 39.6%), the final version retains seven brackets but reduces the rates to 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The 37% rate bracket applies to single filers with taxable income over $500,000 and married filers with taxable income over $600,000.
The final bill leaves the current preferential rates for capital gains and qualified dividends intact. It also retains the 3.8% net investment income tax and the 0.9% additional Medicare tax for high earners.
Increased Standard Deduction, Repeal of Personal Exemptions:
Effective for years after 2018, the bill calls for nearly doubling the standard deduction to $24,000 for married taxpayers filing jointly, $18,000 for heads of household, and $12,000 for single filers while also eliminating personal exemptions, which would be consolidated into the enhanced standard deduction.
State and Local Tax Deduction:
The House version of the bill eliminated the deduction for personal state and local income taxes and capped the amount of deductible state and local property taxes at $10,000. The final bill modifies this slightly by limiting the deduction for all personal state and local taxes to $10,000. Also, the current bill forecloses potential planning opportunities in connection with state and local income taxes by disallowing prepayments of 2018 taxes in 2017.
Effective for divorce or separation agreements executed or modified after December 31, 2018, alimony payments are no longer deductible by the payor spouse and no longer includible in income of the recipient spouse.
In another departure from the House bill, which called for the phase-out and eventual repeal of the estate tax, the final bill retains the estate tax but doubles the exemption amount to $11 million.
The alternative minimum tax (AMT) for individuals is retained but with an increased exemption amount of $1 million for joint filers and $500,000 for single filers. The House bill had called for the outright repeal of the AMT.
Individual Mandate Repeal:
The final bill follows the repeal of the individual mandate under the Affordable Care Act negotiated by the Senate. The repeal is effective after December 31, 2018.
Mortgage Interest Deduction:
The final bill follows the House bill with respect to the mortgage interest deduction on principal residences but increases the amount of allowable indebtedness from $500,000 to $750,000. Additionally, the bill eliminates the deduction for interest paid on home equity loans—such interest was previously deductible on indebtedness of up to $100,000.
Deduction for Medical Expenses:
The final bill retains the itemized deduction for medical expenses as well as lowers the floor to 7.5% of adjusted gross income (down from the current 10%).
Business Tax Reform
Reduced Corporate Rate:
The final bill provides for a flat 21% corporate rate, effective in 2018, which is a slight increase from the 20% contained in the original House bill.
Pass-Through Business Income:
Whereas the House version of the bill provided for a preferential rate of 25% for the business income of taxpayers operating as pass-through entities, the final version achieves pass-through relief through a special deduction. The current deduction is 20%, down from the 23% provided for in the Senate bill. The deduction is generally limited to 50% of allocable W-2 wages of the business or the sum of 25% of such wages plus 2.5% of the adjusted basis of qualified tangible property. Specified service businesses (e.g., accounting and law) qualify for the deduction only if their taxable income is less than $315,000 for joint filers and $157,500 for single filers.
Carried interest income will retain its character as capital gains; however, the bill imposes a three-year holding period (rather than the current one-year period) in order to qualify for such treatment.
Repeal of the Corporate AMT:
The corporate AMT will be fully repealed under the final bill.
Cash Method Limitation Increase: The final bill increases the gross receipts test for use of the cash method of accounting from $5 million to $25 million, thus making the cash method more accessible to small business taxpayers.
Accelerated Cost Recovery:
The bill provides for full expensing of qualified assets acquired and placed in service after September 27, 2017 but before January 1, 2023, with a phase-out between 2024 and 2027.
Interest Expense Limitations:
The bill limits the deduction for net business interest to 30% of the taxpayer’s adjusted taxable income, which is generally measured as EBITDA. Unused deductions can be carried forward indefinitely.
Changes to the NOL Deduction:
Under current law, net operating losses (NOL) generally have a two-year carryback period and a 20-year carryforward period. Under the final bill, the NOL carryback period is generally eliminated, and the carryforward period is indefinite. However, the amount of the NOL carryforward allowed as a deduction would be limited to 80% of taxable income (computed without regard to the NOL deduction).
Modification to Like-Kind Exchange Rules:
The bill limits the availability of like-kind exchanges under Section 1031 to real property only, whereas previously it was available for certain personal property as well.
Section 199 Deduction:
The Section 199 deduction (also known as the Domestic Production Activities Deduction) is repealed.
Certain Tax Credits:
The final bill retains the orphan drug credit (with a reduced credit rate of 25%), the new markets credit, and the work opportunity credit, all of which would have been repealed in the House bill. The research and development credit also remains untouched.
The final bill does not include the phase-out and repeal of certain credits for renewable and alternative energy.
Partnership Technical Terminations:
The final bill repeals partnership technical terminations.
Amortization of Research Expenses:
The final bill requires amortization of research and amortization of certain research and development costs under Section 174 over five years (15 years in the case of foreign research) beginning after 2021.
The limitation on excessive employee compensation under Section 162(m) is modified by eliminating the performance-based exception.
International Tax Reform
Territorial Tax System:
The final bill moves the U.S. from a worldwide tax system to a territorial tax system, accomplished by a 100% foreign dividends received deduction for dividends distributed by a controlled foreign corporation (CFC). To transition to the new regime, the bill requires a one-time deemed repatriation of existing earnings held offshore at a 15.5% rate for cash and an 8% rate for non-cash assets. The bill gives companies eight years to pay the resulting tax. The repatriation rates in the final bill are higher than those proposed in the Senate and House bills.
Foreign Intangible Income:
The final bill adopts the Senate’s global intangible low-taxed income (GILTI) regime and the foreign-derived intangible income (FDII) rules. The GILTI rules impose a minimum tax on a U.S. multinational’s foreign earnings that exceed an amount equal to a standard rate of return on the foreign company’s assets. GILTI tax is paid at the new 21% corporate tax rate after applying a 50% deduction. Only 80% of foreign tax credits can offset the tax. The GILTI rules are triggered when the foreign tax rate on the excessive foreign earnings is below 13.125%.
The final bill also adopts FDII rules, which are similar to a patent box. These provisions grant a special reduced effective tax rate of 13.125% on income from U.S.-held intangibles to the extent that the income is derived from exports of property and services. The final bill does not adopt a provision in the Senate bill that would have allowed for tax-free repatriation of a CFC’s intangibles.
The final bill includes a base erosion anti-abuse tax (BEAT), similar to the Senate version, and rejects the House bill’s controversial excise tax. The BEAT is an AMT designed to curtail excessive earnings stripping through payments to foreign affiliates. The BEAT is imposed at 5% in 2018, increasing to 10% in 2019.
Generally, base erosion payments are deductible cross-border payments to related parties, omitting payments subject to full 30% U.S. withholding tax and cross-border purchases of inventory included in cost of goods sold. A change in the final bill adds related party reinsurance payments to the definition of base erosion payments.
The final BEAT provision also lowers the threshold that triggers the application of the tax. The Senate bill provided that the tax applied if 4% of a company’s total allowable deductions are associated with foreign activity; the final bill uses a 2% threshold for financial institutions and a 3% threshold for others. Lastly, the final BEAT differs from the Senate version by allowing business tax credits, like the investment tax credit and production tax credit, to offset up to 80% of the BEAT tax.
What this Means to You
The final bill is the most sweeping overhaul to our tax code in over 30 years and almost every taxpayer in the U.S. will be affected by this legislation. Many of the provisions in the final bill deal with complex areas of taxation that will require the issuance of Treasury Regulations in order to be fully implemented, which could be a multiyear process. However, since the majority of provisions in the final bill take effect in 2018, taxpayers should consult with their tax advisers now to understand the impact of the new law and identify potential planning opportunities and areas of risk.
This article is not intended to provide legal or tax advice. Tax strategies are highly dependent upon the facts and circumstances of each taxpayer, and no two situations are exactly alike.
Stay connected with EKS&H for more insight into the new law and how it affects you and your business. For more information, please contact your EKS&H tax relationship partner or the head of our tax service area, Joe Bertsch, at firstname.lastname@example.org