Reshaping the code: Understanding the new tax reform law

Tax reform reaches its final destination

Congress has approved and President Trump has signed into law a massive tax reform package that lowers tax rates on corporations, pass-through entities, individuals, and estates and moves the United States toward a participation exemption-style system for taxing foreign-source income of domestic multinational corporations.

Some of the cost of this tax relief is offset by provisions that scale back or eliminate many longstanding deductions, credits, and incentives for businesses and individuals. The unoffset costs—roughly $1.46 trillion for the 10-year budget window covering 2018–2027, according to a revenue estimate from the Joint Committee on Taxation staff—will be added to the deficit.

The newly enacted law, officially known as An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 (the Act), is an amalgam of two competing tax reform measures—one approved in the House on November 16, 2017, and the other approved in the Senate on December 2, 2017—although in some significant ways it tracks more closely with the Senate bill.

That outcome is a likely nod to several factors—most notably, the fact that the legislation moved through Congress under budget reconciliation protections that allow certain legislation to clear the Senate with a simple majority vote rather than the three-fifths supermajority required to overcome procedural hurdles that normally arise in that chamber.

Those protections come with a price, however, including strict budgetary and procedural rules (the so-called Byrd Rules) that, among other things, prohibit reconciliation legislation from increasing the federal budget deficit outside the 10-year budget window and make it more difficult for lawmakers to include provisions that have no impact—or only an incidental impact—on the federal budget.

Another significant factor in play was the GOP’s narrow margin of control in that chamber—a mere four seats in 2017—which left Senate Republican leaders with little room for error in securing final passage.

Our full report provides a detailed discussion of the approved tax reform legislation and observations on key provisions and their implications. Following are some of the report highlights.

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Corporate tax provisions

The Act replaces the prior-law graduated corporate rate structure with a flat 21 percent rate (effective in 2018), and fully repeals the corporate alternative minimum tax (AMT). It also permits items that are amortized under current law to be fully expensed in the year placed in service through 2022, with a phaseout of that benefit thereafter. On the offset side, it imposes new limits on the deduction for net business interest, repeals the section 199 manufacturing deduction and the deduction for state and local lobbying expenses, and disallows like-kind exchanges other than for real property. Additional provisions covered include:

• Business credit provisions 
• Dividends received deduction 
• Modification of the net operating loss deduction 
• Cost basis of specified securities 
• Contributions to capital 
• Additional deductions, exclusions, and income recognition

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Impact on pass-through entities

The Act introduces new rules aimed at providing greater parity between the tax treatment of owners of pass-through entities and corporations, but also includes guardrails intended to prevent pass-through owners from recharacterizing wage income as more lightly taxed business income. It allows a deduction of up to 20 percent of pass-through income, although the deduction is only available for owners of specified service business owners with income under $157,500 (twice that for married filing jointly), and the definition of “specified service” no longer includes architecture or engineering.

The deduction is available to electing small business trusts as well as individuals, and owners are allowed to calculate their maximum deduction based on either 50 percent of their share of W-2 wages paid or a combination of 25 percent of their share of W-2 wages paid plus 2.5 percent of the unadjusted basis of all qualified property. Carried interest income retains its treatment as a capital gain, although it will be subject to a longer holding period (three years as opposed to one year in prior law) in order to qualify. Additional provisions covered include:

• Accuracy-related penalty applied to the 20 percent deduction
• Repeal of technical termination of partnerships
• Recharacterization of certain gains in the case of partnership profits interests held in connection with performance of investment services
• Tax gain on the sale of a partnership interest on lookthrough basis
• Modification of the definition of substantial built-in loss in the case of transfer of partnership interest
• Charitable contributions and foreign taxes taken into account in determining limitation on allowance of partner’s share of loss
• Loss limitation rules applicable to individuals
• Special subchapter S provisions

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International tax issues

The Act moves the United States from a worldwide tax system to a participation exemption system by giving corporations a 100 percent dividends received deduction for dividends distributed by a controlled foreign corporation (CFC). To transition to that new system, the Act imposes a one-time deemed repatriation tax, payable over eight years, on unremitted earnings and profits at a rate of 8 percent for illiquid assets and 15.5 percent for cash and cash equivalents.

The Act generally follows the Senate-passed structure in establishing new base erosion prevention provisions, with modifications. It does not adopt proposals in the House and Senate bills that would have made permanent the lookthrough rules for CFCs under section 954(c)(6); nor does it include a proposed new section 163(n) that would have placed a further limit on interest deductions of multinational corporations by measuring US interest expense and equity against the similar ratios for the worldwide group. Additional provisions covered include:

• Limitation on losses with respect to 10-percent-owned foreign corporations
• Taxation of deferred foreign income upon transition
• Rules related to passive and mobile income
• Special rules for expatriated entities
• Deduction for foreign-derived intangible income
• Treatment of hybrid transactions

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Tax reform provisions for individuals and estates

The Act generally follows the structure of the Senate-approved tax reform bill—and 2017 law—by maintaining seven individual income tax brackets. The top individual income tax rate is 37 percent (lower than in either the House or Senate bills), but includes a significant marriage penalty. It also nearly doubles the standard deduction, repeals the current Pease limitation on itemized deductions, and expands the refundability of the child tax credit.

It retains the deduction for unreimbursed medical expenses (and even offers a boost for 2017 and 2018) and leaves intact the capital gains exclusion on the sale of a primary residence in effect prior to its enactment.

On the revenue side, the measure repeals personal exemptions, retains the individual AMT (albeit with higher exemption amounts), pares back the deduction for home mortgage interest (with existing mortgages grandfathered), and places substantial new limits on the ability of taxpayers to deduct state and local taxes.

In regards to estates, the Act generally follows the Senate-passed bill by retaining the estate tax at its current rate but doubling the exemption amounts. As in the Senate-passed bill, almost all of the Act’s individual tax changes (including all of those just mentioned) and the expanded estate tax exemption amounts expire after 2025.

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A complete picture of tax reform

In addition to in-depth coverage of these key areas, Reshaping the code: Understanding the new tax reform law examines new provisions impacting:

• US insurance companies and products
• Tax-exempt organizations
• Compensation and benefits
• Tax compliance and procedural provisions
• Financial reporting implications
• State business tax issues

Our report also includes a series of side-by-side comparisons showing how the final tax reform legislation provisions align with those in the House and Senate bills and the existing law. Complementing this detailed picture of the tax reform law is a look ahead to the challenges that congressional leaders will likely face as they try to ensure the law works as intended over the coming months and years.

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