On February 26, 2014, House Ways and Means Committee Chairman Dave Camp (R-MI) unveiled his comprehensive tax reform proposal. Chairman Camp released his proposal in discussion draft form, and the bill was not officially introduced as H.R. 1, the bill number House leadership reserved for tax reform. The draft reduces the top individual and corporate tax rates to 25% by eliminating dozens of existing tax expenditures and fundamentally altering the structure of the current code.
Although Chairman Camp received praise from many of his colleagues for moving the tax reform discussion forward, overall responses were mixed. Stakeholder reaction has also been mixed, with some groups praising the draft and others adamantly opposing it.
Looking ahead, Chairman Camp recently announced that he plans to continue educating his colleagues and stakeholders on the discussion draft. Additionally, he intends to hold public hearings on specific portions of the bill. However, he has not indicated that he will mark up the discussion draft in the near future.
This draft is another building block on the construction of tax reform and is the only comprehensive draft in circulation, thus making it more credible. It is unique in that it uses both static and dynamic scores. Static scoring calculates the cost of a proposal, netted against changes in tax revenue, resulting in a difference that may increase or decrease the federal deficit. Dynamic scoring refers to estimates taking into account the macroeconomic effects of tax changes (such as the effect of a tax policy on GDP).
This alert provides a high-level analysis of the key sections of the proposal and their impact. That said, it is important to consider the draft holistically and compare benefits of lower rates to potential loss of deductions and credits.
The draft is intended to significantly reduce the tax compliance burdens on most individual taxpayers through lower rates, streamlining duplicative and confusing tax incentives, and increasing the number of taxpayer benefiting from the standard deduction. The draft would replace the current seven tax brackets with only two: 10% and a top rate of 25% (reduced from 39.6%). Several itemized deductions would be repealed and replaced by a significantly larger standard deduction. Additionally, the draft would streamline up to 15 different education-related benefits.
However, higher income individuals may have a very different result. An additional 10% tax surcharge would apply to joint modified adjusted gross incomes (“AGIs”) over $450,000, calculated by adding back the value of certain above-the-line deductions and eliminating certain qualifying domestic manufacturing income earned by pass-through entities. The draft would also phase out several tax benefits, including itemized deductions, for higher incomes. A broader base and a tax rate close to current rates may result in an effective tax increase, compared to current law. The draft would also repeal the alternative minimum tax, which would simplify the tax calculation for all taxpayers, although the 10% surtax and various limitations and phase-outs may operate as another version of an alternative minimum tax on high-income earners.
As expected, the draft reduces the corporate tax rate from 35% to 25%. This reduction is phased in over a period of five years. Many popular deductions and credits are eliminated or reduced. Last-in/first-out (“LIFO”) inventory, like-kind exchanges, and the Section 199 manufacturing deduction are repealed. Additionally, the research and development credit is made permanent, but reduced; deductions for advertising and research and development expenses are partially or fully amortizable rather than expensed. To mitigate the changes and to mirror the phase in of the reduced marginal tax rates, transition rules phase out some of the deductions, and offer deferred recapture of income resulting from changes in methods of accounting.
The draft moves the U.S. closer to a territorial tax system, although more stringent Subpart F rules retain some aspects of a hybrid system of tax. In general, 95% of foreign dividends received would be exempted from U.S. tax. The remaining 5% would be taxed at regular rates as a proxy for limitations on U.S. deductions for expenses that benefited offshore activity. The CFC look-through rule would be made permanent. Post-1986 accumulated offshore earnings and profits (“E&P”) would be subject to a transition tax, whether or not actually repatriated to the U.S., at two different rates: 3.5% for reinvested E&P, and 8.75% for cash reserves. The draft would retain the deferral mechanism of the current system, but it would resolve the issue of “trapped cash” and allow offshore subsidiaries to freely move money to where it is most efficient.
Foreign tax credits and foreign base company income are significantly changed in the draft. These changes include the expansion and renaming of the passive income basket to “mobile” income; changes to the taxation of foreign base company sales income; and a new category of foreign base company intangibles income. In general, intangibles income would be taxed at a 15% rate, and a minimum tax of 12.5% would be imposed on other Subpart F income.
The draft would have a significant impact on both users and providers of financial products and services. For example, joint filers subject to the 10% surtax would be required to include previously untaxed municipal bond interest in gross income. The 40% tax exclusion for capital gains and dividends would replace the current preferential rate of 20%, effectively taxing these earnings at 15% in most cases. These changes would have a significant effect on investment choices for both individuals and corporations.
The draft also targets several specific types of financial services firms on the grounds that such institutions enjoy preferential treatment under the current Internal Revenue Code. A special surtax would apply to the largest banking organizations and institutions deemed systemically important by the U.S. government; a change in the treatment of “carried interest” would provide for ordinary income treatment in the case of certain service partnership interests in hedge funds; and new “mark-to-market” treatment for derivatives used for investment purposes would require taxpayers to determine and report the fair value of their positions at the end of each year.
The draft is intended to create parity between the taxation of pass-through entities and corporations. However, if enacted into law, certain provisions in the draft would result in distortions between pass-throughs and corporations and between pass-throughs of different types. Pass-through income is taxed at the partner or shareholder level, and the top individual rate of 25% matches the 25% corporate rate. The 10% surtax on individual income may apply to certain pass-through income, resulting in a significantly higher tax rate compared to a corporate entity. Further, the 10% surtax applies to pass-through income that is generated from a service-type business, but it does not apply to pass-through income generated from a manufacturing operation (domestic manufacturing income). This difference may be intentional in order to promote U.S. competitiveness in the manufacturing sector. In practice, it creates a bias against service businesses or other types of pass-through entities, like hedge funds.
The draft also aims to close several perceived loopholes in the pass-through sector. It expands the scope of partnership distributions subject to employment tax and provides a bright line computation to determine the portion of pass-through income subject to employment taxes both for partnerships and Subchapter S corporations.
The draft proposes significant changes to the tax treatment of charitable contributions. For example, under the draft, an individual’s charitable contributions could be deducted only to the extent they exceed 2% of the individual’s AGI. Additionally, the AGI limitations would be simplified. The current limitation of 50% for cash contributions and 30% for capital gain property to public charities and certain private foundations would be harmonized at 40%. Additionally, the deductibility of certain contributions of real property would be limited to basis.
The draft also proposes changes to the unrelated business income tax rules. For example, there is a provision requiring tax-exempt organizations to calculate separately the net unrelated taxable income of each unrelated trade or business. This provision prevents organizations from using losses generated by one unrelated business to offset income derived from another unrelated business as is currently the case. The draft also proposes changes to rules pertaining to private foundations, tax-exempt executive compensation, excess benefit transactions, and self-dealing transactions.
Retirement Security and Employee Benefits
The draft narrows the availability of traditional treatment of IRAs and 401(k)s. Specifically, the draft prohibits traditional IRAs going forward; instead, it requires Roth treatment of IRAs and eliminates the Roth IRA income limitations. With respect to 401(k)s, employees would generally be able to contribute up to half the maximum contribution amount into a traditional account; for any excess, contributions would be to a Roth account. The draft would also make a number of changes to rules governing employer-provided retirement plans—for example, by aligning the rules applicable to different types of plans.
The draft would also change several employee benefits rules by modifying the limitation on excessive employee numeration, modifying fringe benefits rules, limiting the exclusion for employer-provided housing, repealing the exclusion for education assistance, and repealing the exclusion for employee awards.
The draft cuts back significantly on the Internal Revenue Code’s various energy-related provisions. In particular, the draft repeals numerous tax provisions relating to alternative energy, including provisions that expired at the end of last year. Most notably, the draft would phase out and repeal the production tax credit for renewable electricity from wind, biomass, and other sources by stripping the credit’s inflation adjustment and blocking new facilities from receiving the incentive. The draft would also cut back on incentives for alternative energy by repealing tax credits for investments in solar electricity property (after 2016), credits for the production of biofuels and alternative fuels, as well as tax incentives for energy efficient homes, energy efficient appliances, electric vehicles, alternative fuel vehicles, and preferential cost recovery rules relating to alternative energy. Additionally, the draft would repeal a number of tax provisions that apply to conventional energy, including the percentage depletion allowance, tax incentives for clean coal, the enhanced oil recovery credit, and the LIFO method of inventory. However, the draft would retain the deduction for intangible drilling costs and several other tax preferences for conventional energy.
The draft would repeal the Modified Accelerated Cost Recovery System and lengthen depreciable lives for property placed in service after December 31, 2016. Instead of accelerated cost recovery, businesses would depreciate property through straight line depreciation under the Alternative Depreciation System. The draft would also repeal bonus depreciation and the accelerated 15-year life that currently applies to qualified leasehold, restaurant, and retail improvements.
Importantly, the draft would require the Treasury Department to submit a new schedule of economic depreciation to Congress. This provision is similar to the approach taken under the tax reform staff discussion draft on cost recovery released by former Senate Finance Committee Chairman Max Baucus (D-MT).
Bonds, Infrastructure, and Development
The draft proposes to repeal private activity bonds and advance refunding bonds. Additionally, the 10% surtax on earned income over $450,000 for joint filers would apply to certain tax-exempt bond interest that is currently not taxed. The draft also proposes to repeal a number of community-development tax incentives, including provisions related to the New Markets Tax Credit, Empowerment Zones and Enterprise Communities, and Renewal Communities.
Time to Comment
Chairman Camp’s proposal is extremely detailed and faces an unclear future. There will be winners and losers, depending on each taxpayer’s facts and circumstances. To fairly and accurately assess the impact of the draft and reach a decision about whether to engage, each taxpayer should conduct a tax diagnostic. Please let us know if we can be helpful in assisting you to identify proposals and determine their effect on you and your business.
The House Ways and Means Committee staff is actively seeking feedback on the proposal, and now is the time to provide comments. Even if comprehensive tax reform does not occur in 2014, Congress now has a “menu” of scored tax provisions at their disposal, which could be used as pay-fors for other legislative priorities.