Tax Alert: "What Does New Tax Bill Mean for Individuals and Business Owners?"
Last night the Senate passed the Tax Cuts and Jobs Act (the “Tax Reform Act of 2017”). The House is expected to re-vote on it this afternoon. Kevin Brady, Chairman of the House Ways and Means Committee, and Paul Ryan, Speaker of the House, have presented the Tax Reform Act of 2017 as the most significant tax legislation since the Tax Reform Act of 1986. The President is expected to sign it into law before Christmas.
Corporations are clearly the winners
The new bill will eliminate the corporate alternative minimum tax. The corporate rate will drop from a maximum 35% to a flat 21%. Shareholders will still be entitled to the lower 20% capital gains rate on long-term capital gains and qualified dividend income. Other changes are not as favorable, but in many cases are not limited to corporations – net operating loss carrybacks and carryforwards will be significantly limited, and every business, subject to certain exceptions, is now subject to additional limitations on business interest deductions.
Individual Taxpayers Receive Only a Temporary Benefit
On the personal income tax side, the Tax Reform Act of 2017 leaves much to be desired. To the extent there are tax cuts for individual taxpayers, these cuts sunset in 2025. This is not the first time Congress has implemented provisions only temporarily, to have them revert back to the pre-implementation provisions should they not be renewed by subsequent legislative action. Efforts to simplify the Internal Revenue Code have seemingly failed.
Individuals are still subject to the alternative minimum tax, generally with increased exemption amounts. The marginal regular tax brackets are generally reduced, although for some ranges of taxable income some taxpayers will see their highest marginal rate increase. The highest rate fell from 39.6% to 37% for single taxpayers making more than $500,000 and married taxpayers filing jointly making more than $600,000 (Congress did not eliminate the marriage penalty for double income couples).
For taxpayers that itemize their deductions, Congress limited the mortgage interest deduction for future home purchases to $750,000 of value (which can include both a primary residence and one secondary home), while capping the deduction for state and local property and income taxes at $10,000 per year in the aggregate.
Business Owners Receive a “Phantom” Deduction
Individuals who are also entrepreneurs are allowed a “phantom” (based on phase-outs described below) deduction of 20% to offset their qualified business income (as defined in the bill). This deduction is limited to 50% of the wages that the taxpayer directly or indirectly pays to employees in the qualified business unless the taxpayer earns less than $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly. (For income levels between $157,500 and $207,500, and $315,000 and $415,000, respectively, the limitation on the deduction to 50% of wages paid to employees in the business is phased, but springs into full effect once taxable income hits $207,500 for singles and $415,000 for joint returns.)
At the last minute an alternative limitation was inserted for businesses that have few or no employees but that have capital assets, with the 20% deduction limited under this alternative to the sum of (a) 25% of employee wages, plus (b) 2.5% of the unadjusted basis of qualified property. This appears to help capital intensive businesses like real estate developers.
For most professionals, i.e. doctors, dentists, lawyers, and most financial advisors (but not engineers and architects), this 20% deduction is phased out for income in excess of $157,500 for single taxpayers ($315,000 for married taxpayers filing jointly), and the 20% deduction is completely eliminated if such professional’s income exceeds $207,500 ($415,000 for married taxpayers filing jointly). The deduction does not apply against guaranteed payments received by a partner. Based on these phase-outs described above, this 20% deduction will likely be in large part phased out for most entrepreneurs who could otherwise benefit from it.
International businesses, individuals and pass-through businesses are still subject to worldwide taxation
With respect to the U.S. taxation of international businesses, individuals and pass-through businesses are still subject to worldwide taxation. C corporations on the other hand have moved to a quasi-territorial system with respect to foreign income earned through foreign corporations. However, both individual taxpayers and C corporations have to pay a toll tax on accumulated foreign earnings in order to move to this new system, with such toll tax equal to 15.5% of earnings held in cash and 8% on earnings reinvested in business assets (which at the election of the taxpayer can be paid over an 8-year period with the amounts payable generally back loaded).
In return, U.S. corporate shareholders of foreign corporations are allowed a 100% dividend received deduction on foreign earnings received from such foreign corporations in the future, although this deduction is not allowed to individual owners of foreign corporations. All taxpayers will be subject to a minimum income tax on their foreign corporations’ foreign earnings going forward (at a minimum rate of approximately 10%) for income in excess of certain levels.
The extent to which the 10% minimum tax applies depends in large part on (a) the magnitude of the foreign corporation’s investment in tangible assets, and (b) whether the foreign corporation is subject to foreign corporate income tax above a 10% rate. For hybrid ownership structures, where an S corporation owns a foreign corporation, the S corporation individual shareholders may defer payment of the toll tax until they sell the business or unwind it, but they will never get the benefit of the 100% dividend received deduction on dividends distributed by their foreign corporations.
Business Owners Should Reevaluate Their Business Structure
Most business owners should reevaluate their legal structure and determine whether there is a better alternative to take advantage of the changes under the Tax Reform Act of 2017.
Given the higher tax rates imposed on personal income (and additional limitations on deductible expenses), many business owners should consider operating their business through a C corporation, especially if the business has significant international operations. The lower 21% rate is permanent, which allows better forecasting for long-term investments.
Congress fixed a last minute error in the House bill, which now clarifies that only capital contributions made by a government entity or by a customer in aid of a construction project will be taxable to a corporation (thus other capital contributions to a corporation can generally be made tax free, consistent with long standing existing law). The existing tax policy favorable to the corporate form of business has been expanded.
The Tax Reform Act of 2017 makes foreign investors subject to income tax on sales of U.S. partnership interests. Foreign investors should think twice before investing in the U.S through a partnership.
The Tax Bill Goes Into Effect Immediately
Once the President signs the bill, the legislation will have immediate effects and long-term consequences, with most, but not all, of its provisions going into effect at the beginning of 2018.
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