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Comprehensive Tax Reform Plan Proposed By The GOP; President Releases Federal Budget Proposals For 2015

Tax Alert | May 1, 2014
By: William C. Hussey and Suzanne A. Prybella

A comprehensive tax reform plan was released on February 26, 2014 from House Ways and Means Committee Chairman Dave Camp (R-Mich.).  The “The Tax Reform Act of 2014” (the “Act”) seeks to simplify the tax code and lower rates for individuals and corporations while raising the same level of revenue.  The proposed reforms are revenue-neutral. However, in order to stay revenue-neutral while lowering rates, the plan eliminates or reduces several popular tax breaks.  The Act is the most comprehensive reconstruction of the U.S. tax code since 1986 and is considered by many to be long overdue. 

However, it is unlikely that the plan will gain any traction during 2014, partially due to partisan disagreement over whether tax-code changes should raise additional revenue, but in large part because members of Congress are primarily concerned with positioning their respective parties for the upcoming midterm elections.  At the very least, however, the plan may serve as a blueprint for Congress to use in the future in their efforts to revise the current tax code.  On March 4, 2014 the President released his federal budget proposals for fiscal year 2015 (the “Budget Proposal”), which included, among other things, the expansion and permanent extension of the earned income tax credit and the research tax credit, a number of new international tax proposals, and a renewed push for combining infrastructure investments with business tax reform.  The Senate has decided not to pass its own budget for the 2015 fiscal year.

Individual Reforms

The Act would repeal or modify many different deductions, credits, and other special treatment of individual income and expenses.  Some of the major changes are highlighted below: 

  • Rate & Tax Brackets – The top income tax rate would drop from 39.6% to 25% and the number of income tax brackets would be reduced from seven to two.  A surtax would be imposed on certain types of income above $450,000 ($400,000 for single filers), essentially creating a third tax bracket of 35%.  The surtax would not apply to capital gains or investments.
  • Capital Gains & Dividends – Long-term capital gains and qualified dividends would be taxed at the same rates as ordinary income, but 40% of gains and dividends would be excluded.
  • Standard Deduction – The standard deduction would be increased to $22,000 ($11,000 for single filers), subject to a phase out.   
  • Charitable Deductions – The charitable deduction would be limited to charitable contributions in excess of 2% of AGI.  The deadline for making tax deductible contributions for a given year would be extended to April 15 of the following year.
  • AMT – The alternative minimum tax would be abolished.
  • Personal Exemption – The personal exemption would be repealed and consolidated into the larger standard deduction. An additional standard deduction of $5,500 would be available for taxpayers with a qualifying child, subject to a phase out.
  • State & Local Tax Deduction – The deduction for state and local taxes (e.g. income, real property and sales) would be repealed.  However, individuals would still be allowed a deduction for state and local taxes paid or accrued in carrying on a trade or business.
  • Home-related Tax Changes – The cap on the mortgage interest deduction for new mortgages would be gradually reduced from $1 million in debt to $500,000 in debt.  The rule allowing the exclusion of up to $500,000 of gain ($250,000 for single filers) from the sale of a home used by the taxpayer as a principal residence would be revised to require the home be used as the taxpayer's principal residence for five out of the previous eight years (instead of the current two out of five years requirement). The exclusion would subject to a phase out.  The exception to the 10% penalty (on early distributions from retirement plans and IRAs) to pay for first-time homebuyer expenses would be repealed, as would the credit for residential energy efficient property.
  • Education Related Credits – The existing fifteen tax breaks for higher education would be reduced to five: the American Opportunity Tax Credit (revised and made permanent), the deduction for work-related education expenses, the exclusion of scholarships and grants, gift tax exclusion for tuition payments, and tax-free 529 savings plans.  The revised American Opportunity Tax Credit would provide a 100% tax credit for the first $2,000 of certain higher education expenses and a 25% tax credit for the next $2,000 of such expenses. It would be available for up to four years of higher education, and eligible expenses would include tuition, fees and course materials. The first $1,500 of the credit would be refundable, and it would be subject to a phase out.  The Budget Proposal would also permanently extend the American Opportunity Tax Credit for tax years beginning after December 31, 2017.
  • Retirement Savings– For future contributions, up to $8,750 could be contributed to either a traditional or Roth IRA account. Any excess contributions would be dedicated to a Roth-style account. The income eligibility limits for contributions to Roth IRAs would be eliminated. In addition, the special rule permitting recharacterization of Roth IRA contributions as traditional IRA contributions would be repealed.
  • Misc. Tax ProvisionsIn addition to items discussed above, the Act would repeal a number of other provisions such as the deduction for personal casualty loss, the deduction for tax preparation expenses, the itemized deduction for medical expenses, deduction for alimony payments, deduction for moving expenses, deductions and exclusion for medical savings accounts, the Pease limitation and the 2% floor on miscellaneous itemized deductions.  The Budget Proposal would  reduce the value of itemized deductions and other tax preferences to 28% for families with income in the top three highest tax brackets (33%, 35%, and 39.6%) and it would require millionaires to pay no less than 30% of income (after charitable contributions) in taxes (referred to as the “fair share tax” or the “Buffet Rule.”)

Business Reforms

The Act would repeal or modify many different deductions, credits, and other special treatment of various types of business income and expenses.  Some of the major changes are highlighted below:

  • Corporate Tax Rate – For tax years beginning after Dec. 31, 2018, the maximum corporate tax rate would drop from 35% to 25%.  The lower tax rate would be phased in beginning in 2015 and for each of the “phasing in” tax years a 25% taxable rate would apply to taxable income in an amount up to and including $75,000.  The maximum corporate tax rate on net capital gain would be repealed.
  • Depreciation Deduction – For property placed in service after Dec. 31, 2016, the modified accelerated cost recovery system (MARCS) would be eliminated and replaced with a straight line depreciation method.
  • Expensing Deduction – For tax years beginning after Dec. 31, 2013, a taxpayer could expense up to $250,000 of the cost of qualifying property placed in service for the tax year. The deduction would be phased-out for every dollar the total qualifying additions exceed $800,000.  Both amounts would be indexed for inflation for tax years beginning after 2014.  The amortizable life “Section 197 intangibles,” would be extended to 20 years (it is currently 15 years).  Alternatively, the Budget Proposal would permanently extend increased expensing of qualified property with a $500,000 deduction limit and a phase-out beginning at $2 million (indexed for inflation for tax years beginning after 2013).
  • NOL Deduction – Generally, for tax years beginning after Dec. 2014, a corporate net operating loss would only be permitted to offset 90% of the corporation’s taxable income in the carryback or carryforward year.  Carryovers to other years would be adjusted to reflect the limitation.
  • Net Earnings from Self-employment – For tax years beginning after 2014, the tax imposed under the Self-Employment Contributions Act (SECA) would apply to general and limited partners of a partnership, LLC and shareholders of an S-corporation, to the extent of their distributive share of income or loss. A new deduction designed to approximate the return on invested capital would be used in determining net earnings from self-employment.  The Budget Proposal would do so as well. 
  • Carried Interest – For tax years beginning after 2014, partnership distributions and dispositions of partnership interests held in connection with the performance of services would be subject to a rule that characterizes a portion of any capital gains as ordinary income.  The provision would not apply to a partnership engaged in real property trade or business.  The Proposed Budget would also tax certain “carried interest” income as ordinary income instead of capital gains.
  • Like-kind Exchanges – The “like-kind exchange” rules of Section 1031 would be repealed meaning that taxpayers could no longer defer gain on the sale or exchange of appreciated property by exchanging it for property of a like-kind.  Alternatively, the Budget Proposal would modify like-kind exchange rules for real property to limit the amount of capital gain deferred under to $1 million (indexed for inflation) per taxpayer per tax year.
  • Misc. Tax ProvisionsIn addition to items discussed above, the Act would repeal a number of other provisions such as the work-opportunity tax credit, the credit for biodiesel and renewable diesel used as fuel, the credit for alcohol, etc. used as fuel, the enhanced oil recovery credit, the employer-provided childcare credit, the credit for carbon dioxide sequestration, the credit for employee health insurance expenses of small employers and the energy credit.

International Reforms

The Act contains a several significant changes to the taxation of both foreign income and the U.S. source income earned by foreign taxpayers.  Some of the major changes are highlighted below:

  • Dividend Deduction/Exemption System – The existing dividend received deduction would be replaced with a 95% exemption system, under which 95% of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend. 
  • Other Foreign Tax Credit (FTC) Changes – No FTC would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend received deduction would apply.  Only expenses that are directly attributable to income earned by a foreign subsidiary would be allocated against foreign-source income.  Income derived from the sale of inventory produced partly in, and partly outside, the United States would be allocated and apportioned on the basis of the location of production activities.  Passive category income would be renamed “mobile category” and would be expanded to include a shareholder's foreign base company sales income and foreign base company intangible income. The special rules for treating financial services income as general category income would be eliminated.
  • Modification of Limitation on Earnings StrippingUnder current law, a U.S. corporation generally may deduct interest payments, including payments to a related party.  However, payments to such related parties are disallowed to the extent the taxpayer has “excess interest expense.” Excess interest expense is the amount of net interest expense in excess of 50% of the taxpayer's adjusted taxable income. A carry forward of the disallowed amount is permitted.  Under the Act, the threshold for excess interest expense would be reduced to 40% of adjusted taxable income and corporations would no longer be permitted to carry forward any excess limitation.
  • Limitation on Treaty Benefits for Certain Deductible PaymentsIf a payment of certain income (such as interest, dividends, rents, and annuities) to a foreign recipient generates a United States tax deduction for the taxpayer, and the payment is made by an entity that is controlled by a foreign parent to another entity in a tax treaty jurisdiction that is controlled by the same foreign parent, then the statutory 30% withholding tax on such income would generally not be reduced by any treaty.

If you would like to discuss how any of these changes may affect your business or personal income tax situation, or have any other tax or estate planning questions, please contact, Bill Hussey (215-864-6257; husseyb@whiteandwilliams.com), John Eagan (212-868-4835; eaganj@whiteandwilliams.com),  Kevin Koscil (215-864-6827; koscilk@whiteandwilliams.com) or Suzanne Prybella (215-864-7188; prybellas@whiteandwilliams.com).  The Tax and Estates Practice Group at White and Williams is committed to keeping our clients and friends up to date with important tax developments. 

IRS Circular 230 Notice:  To ensure compliance with certain regulations promulgated by the U.S. Internal Revenue Service, we inform you that any federal tax advice contained in this communication (including any  attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code, or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein, unless expressly stated otherwise.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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