US Tax Reform: Final TCJA Highlights
On December 20, 2017, Congress passed H.R. 1 – the Tax Cuts and Jobs Act (TCJA) – providing for the largest changes to the US tax code since 1986 and President Trump signed the bill into law on December 22, 2017. As we have done previously, we have highlighted the changes made to US Federal tax law under the Tax Cuts and Jobs Act:
Individual Tax Provisions
TCJA will maintain seven tax brackets but cuts the rates at every level and raises many of the income thresholds to qualify for the higher bracket. For example, the top rate is reduced to 37 percent (down from 39.6 percent) and would apply only to married individuals that earn more than $600,000 (as opposed to the current top level kicking in at $470,700). Note that this is also the level at which the highest long-term capital gains rate kicks in, resulting in a further tax savings for high income taxpayers. Click here for a list of all the tax brackets for each type of taxpayer.
- The cut to individual tax rates is not permanent and unless a future Congress acts, many Americans will see their tax bills actually increase starting in 2027.
- The bill gets rid of personal exemptions and replaces them with an enhanced standard deduction ($24,000 for married couples and surviving spouse, $18,000 for head of household, and $12,000 for individuals).
- In order to ameliorate any negative effects from the fact that personal exemptions will no longer be allowed, the bill allows the child tax credit to increase from $1,000 now to $2,000 and the phase out amounts will be raised substantially. In addition, the credit is refundable up to $1,400 for certain filers.
- Another major change and one that has caused a lot of controversy is that the bill caps the amount of the deductions for state and local property, income, and/or sales tax. Whereas these taxes used to be deductible if the amount exceeded the standard deduction amount, single filers and those taxpayers who are married filing separately will have their deduction capped at $5,000 and married filing jointly taxpayers will have their deduction capped at $10,000. Obviously, this will have an impact on those living in high tax states.
- The bill eliminates various deductions such as tax preparation expenses, unreimbursed business expenses, and the deduction for moving expenses. That said, the medical expense deduction stays and is more generous than current law as medical expenses will be deductible in excess of 7.5% of adjusted gross income (as opposed to the current 10% threshold) for 2017 and 2018.
- TCJA repeals the deduction for home equity indebtedness (currently up to $100,000) but will keep the deduction for acquisition indebtedness at the current level of up to $1 million for mortgages taken out before December 15, 2017. After this date, the mortgage interest deduction will be capped at $750,000. Note that the bill does not contain the provision requiring taxpayers to reside in their homes five out of the last eight years (as opposed to two out of the last five years) to qualify for the exemption of the first $250,000 ($500,000 for married filers) gain on the sale of a principal residence.
- Although the bill does not eliminate the individual Alternative Minimum Tax (AMT), it has raised the exemption amounts for all types of taxpayers and has substantially increased the exemption amount phase-out thresholds.
- The bill significantly changes the treatment of alimony for years after 2018. For any divorce finalized after December 31, 2018 the spouse paying alimony will not be allowed to deduct such payments and the spouse receiving alimony will no longer include it in taxable income. This makes the US tax treatment of alimony similar to the tax treatment in the UK.
For our clients living outside of the United States, the key thing to note is that, unlike the changes to the US corporate tax that makes this tax more of a “territorial” system, US individual taxation has maintained the system of “worldwide taxation”. Accordingly, US taxpayers will still need to declare their worldwide income and assets and utilize the foreign tax credit to mitigate any double taxation effects. Also, the legislation does not get rid of any of the Foreign Account Tax Compliance Act (FACTA) provisions.
Most clients living in a higher tax jurisdiction, such as the United Kingdom, may not notice any major differences to their underlying US tax bill as their local country taxes will be higher than the US tax amount. That said, the decrease in the US tax rates should have the effect of increasing a taxpayer’s amount of foreign tax credit carryovers which can be used for other purposes.
It should be noted that certain changes that were discussed during the process did not make it to the final bill. Here are a few of them:
- ACA taxes – This is the Net Investment Income Tax (NIIT) that is due on certain passive income above certain thresholds depending on filing status. While the Individual mandate payment was set to $0, the NIIT tax remains.
- Head of Household filing status-While on the chopping block, in the end, this filing status remains an option for certain taxpayers.
- Student Loan Interest/Life Time Learning Credit-Not only do these deductions/credits remain, but there are additional deductions related to private/home school fees available under the new law.
- Carried Interest-While Trump campaigned on doing away with this tax break, it remains with only minor changes.
- Retirement accounts (401K, IRA, etc.)-No changes were made, though there was various talk of major reform, none made it to the final bill. The one exception is the ability to reverse a Traditional IRA to Roth IRA conversion. This re-characterization will no longer be allowed under the current rules.
Corporate Tax Provisions including International Provisions
- Under TCJA, the US corporate tax rate will drop from the current 35 percent to 21 percent and unlike the individual tax cuts that will expire in 2027, the cut to the corporate tax rate is permanent. The new lower rate (note there is no longer a system of graduated rates) applies to tax years ending after December 31, 2017.
- For tax years beginning after December 31, 2017, the bill eliminates the Corporate AMT.
- The bill allows companies to fully expense new buildings and other investments for the next five years instead of subjecting them to periodic depreciation. Lower expense percentages will apply for 2023-2027.
- TCJA increases the amount that a taxpayer may expense under Section 179 to $1 million and the phase out threshold to $2.5 million.
- With respect to the R&D credit, the bill preserves the R&D credit but any amounts paid or incurred in tax years beginning after December 31, 2021 will have to be deducted over time rather than being expensed immediately.
- In general, the amount of interest expense that can be deducted under the bill will be limited to the sum of business interest income plus 30 percent of the adjusted taxable income of the taxpayer for the taxable year.
- The bill will also limit the Net Operating Loss (NOL) deduction to 80 percent of taxable income for tax years beginning after December 31, 2017, and repeals the two-year carry-back for most taxpayers.
- Another key change that the TCJA makes is that the US corporate tax systems shifts from a worldwide system in which companies are taxed on all income earned all over the world (if repatriated or caught by the CFC rules) to a territorial system, whereby dividends from 10% owned foreign corporations are given a participation exemption and are not subject to US taxation. Note that most of the current subpart F and PFIC rules are still applicable.
- In order to transition to a shift from worldwide taxation to a more territorial system, the Senate bill allows US corporations to bring back money they have overseas at an effective tax rate of 15.5 percent to the extent of the corporate US shareholder’s pro-rata share of earnings held in cash of any specified foreign corporation. For all other earnings and profits, the effective rate of tax drops to 8 percent. The new US tax on the deemed repatriation may be paid in installments over 8 years. Note that these provisions apply to all CFCs, including those owned by individuals.
- The bill adds a new provision that provides domestic corporations that are not RICs or REITs with reduced rates of US tax on their foreign-derived intangible income (“FDII”) and global intangible low-taxed income (GILTI”). For taxable years beginning after December 31, 2016 and before January 1, 2026, the effective tax rate on FDII is 13.125 percent and on GILTI is 10.5 percent.
- In addition, each US shareholder of a CFC (including individuals) will be required to include their share of the GILTI inclusion amount in gross income.
- Given the new participation exemption, the bill repeals the deemed-paid credit that was allowed under section 902.
- The bill changes the sourcing of income from the sales of inventory from the place where title passes to the place where production occurs.
- With respect to foreign tax credits, the bill creates a new foreign tax credit basket for foreign branch income (i.e., business profits of a US person that are attributable to one or more qualified business units (QBUs)).
- TCJA expands the definition of “US Shareholder” to include any US person who owns 10 percent or more of the total value of shares of all classes of stock of a foreign corporation and eliminates the requirement that corporation must be controlled for an uninterrupted period of 30 days before the subpart F rules apply.
- The bill adds a base erosion minimum tax so that an applicable taxpayer is required to pay a tax equal to base erosion minimum tax amount (“BEMTA”) for the tax year. BEMTA is the excess of the percentage (which varies based on year and type of taxpayer) of “modified taxable income” over regular tax liability reduced by certain credits. Note that this provision is mainly aimed at large corporations.
US corporations are one of the main beneficiaries of TCJA as the US corporate tax rate drops from 35 percent (one of the highest in the world) to a much more competitive 21 percent. In addition, the US corporate tax rate system moves from a system of worldwide taxation to a more territorial system (similar to many other countries around the world). One of the consequences of the high rate on worldwide income is that many US multinationals have substantial amounts of cash offshore.
Congress, in passing TCJA, is hoping that the deemed repatriation tax, as well as the move to a territorial system, will encourage US multinationals to use the repatriated cash to invest in US jobs and staff.
Interestingly, the deemed repatriation tax seems to apply to all US shareholders of CFCs, including individuals. Therefore, for our individual clients that have set up a foreign corporation and own more than 50 percent of this corporation, it would appear that any unrepatriated earnings and profits as of December 31, 2017 from these corporations will be subject to deemed repatriation tax. Exactly how this works remains to be seen as we wait for the Department of Treasury to release regulations with respect to the changes in the bill. We will have other blogs posts on this (and other provisions) once guidance has been issued.
We often give advice to corporate clients who want to invest in the US on how to structure their affairs. Given the lower US corporate tax rate and move to a territorial system, my colleague James Debate has asked the question, US Tax Reform: how will the new law affect your business?
Provisions that will affect our Fund Clients
- In order for any carried interest (referred to in the statute as an Applicable Partnership Interest or API) to receive long-term capital gains treatment, the Bill requires a three-year holding period rather than the normal one-year holding period for long-term capital gains. This three-year holding period applies notwithstanding an election under Section 83(b) or any of the other provisions in Section 83.
- With respect to the Unrelated Business Income Tax, for entities with one or more unrelated trade or business, unrelated business taxable income (UBTI) shall be computed separately with respect to each such trade or business and will not account for net operating losses in any other trade or business.
- Under TCJA, UBTI includes any expenses paid or incurred on certain fringe benefit expense for which a deduction is disallowed.
- The bill repealed the prohibition on “downward” attribution of stock ownership from a foreign person to a US person. As a result, stock owned (directly, indirectly, or constructively) by a foreign person will be attributed downward (i) to any US partnership in which that foreign person has any interest and (ii) to any US corporation in which that foreign person’s ownership interest is at least 50%. Practically speaking, this means that direct and indirect US investors could be classified as “as US shareholders” (even if they do not meet the 10% threshold), foreign portfolio companies could be classified as “controlled foreign corporations” (CFCs), and US investors that hold interests in newly classified US shareholders that are pass-through entities could be subject to subpart F exposure and reporting obligations. Note that although the legislative history on the repeal of downward attribution provides that it is not intended to cause a foreign corporation to be treated as a CFC as a result of the downward attribution, the statutory language does not support the limited application that the legislative history discusses and it remains to be seen how the Department of Treasury will deal with this.
Other Pass-Through Tax Provisions
- With respect to pass-through entities (such as partnerships, LLCs and S corporations), under TCJA, most pass-through businesses will not have to pay tax on 20 percent of their income (and any remaining tax is paid based on individual rates and not corporate rates).
- The availability of this 20 percent deduction is limited for owners of “specified services trade or businesses”, which generally includes professional services firms (such as law firms, accounting firms, and consulting firms), doctor’s offices and other “service businesses” in the fields of actuarial sciences, performing arts, athletics, financial services, or brokerage services (note that engineering and architecture firms have been specifically excluded from this definition). For such businesses, the full 20 percent deduction is only available if a taxpayer’s taxable income (computed without regard to deduction) is less than a “Threshold Amount” – for joint filers, this is $315,000 and for single filers, this is $157,500.
- For taxpayers who are not owners of a specified services trade or business with taxable income that exceeds the Threshold Amount, the deduction is limited to the lesser of (1) 20 percent of qualified business income or (2) the greater of (a) 50 percent of “W-2 wages” with respect to a qualified trade or business or (b) the sum of 25 percent of the “W-2 wages” plus 2.5 percent of the unadjusted basis of certain depreciable property.
- However, for taxpayers that are owners of a specified services trade or business, the deduction begins to phase out at the first dollar above the Threshold Amount and is completely eliminated once taxable income equals the Threshold Amount plus $50,000 (or plus $100,000 for joint filers).
- Unlike the House bill, which has proposed to eliminate the estate tax by 2024 (and to substantially increase the exemption amount to $10 million until then) but keep the step up in basis in estate assets, the Senate bill keeps the estate tax (and step up) but also increases the exemption amount to $10 million, effective for years after December 31, 2017.
We anticipate that some of our clients that own foreign companies that can elect to be treated as a flow-through entity will wonder whether they too can take advantage of the 20 percent deduction. Sadly, in order to be “qualified business income” (which forms the basis of the deduction), items are treated as qualified items of income, gain, deduction, and loss only to the extent that they are effectively connected with the conduct of a trade or business within the United States. This means that businesses that are conducted completely offshore cannot take advantage of the 20 percent deduction. That said, for clients who are currently living and operating a business in the US or those that are thinking about setting up in the US in the near future, it may make sense to look at using a flow-through entity rather than a corporation.
Estate and Gift Tax Provisions
- After much discussion, the Bill did not eliminate the Estate and Gift Tax and the unified regimes remains with a top tax rate of 40 percent. Furthermore, the step-up in basis upon death also remains.
- That said, the basic exclusion amount increases from $5 million to $10 million and as this amount is indexed for inflation occurring after 2011, the exclusion amount for 2018 will be $11.2 million per person. Note that unless a future Congress acts, the increased exclusion amount sunsets at the end of 2025.
As always, if you have any questions on this or any other tax query, please don’t hesitate to contact us.