This week MMG was tracking key issues in the House and Senate tax reform bills, among them interest deductibility, pass-through treatment, carried interest and unrelated business income tax. The differences between the two chambers’ bills are outlined below, as are potential changes to the Dodd-Frank Act and a bill that will prevent a government shutdown—for now.
Dodd-Frank Changes in the Works
The Senate Banking Committee advanced what would be the first significant changes to the Dodd-Frank Wall Street Reform and Consumer Protection Act in a 16-7 vote on Tuesday, garnering enough bipartisan support to overcome a Democratic filibuster, The Hill reports. Mostly geared toward community banks and credit unions, the proposed legislation would, among other things, raise the limit for what is considered a “systematically important financial institution” to $250 billion in assets. Currently, a bank holding company is considered a SIFI if it has $50 billion in assets.
Next Step in Tax Reform (Pass the SALT?)
After the Senate passed its version of the tax reform bill late on Sunday, the next step is an official conference committee in which the House and Senate will work out the differences in their bills, CNN reports. All signs point to a speedy conference process, with the Senate making concessions on several key provisions, such as adopting the House plan’s approach to the state and local tax deduction. As the conference convenes, here are the key issues ACG is tracking, and the differences between the Senate and House versions of the bills:
The House bill subjects every business to an interest deduction allowance for net interest expense in excess of 30 percent of a business’s adjusted taxable income (defined as EBITDA). Exemptions to the rule are:
- Small Business Exemption: For businesses with average gross receipts of $25 million or less, the rule does not apply
- Public Utilities Exemption
- Real Estate Exemption: Rule does not apply to real property trade associations or businesses
- Auto Dealer Exemption: For taxpayers that paid or accrued interest on “floor plan financing indebtedness”
The Senate bill maintains business ID limitation to 30 percent of EBIT (definition for adjusted taxable income)
- Small Business Exemption: 100 percent interest deductibility for small businesses—those with average annual gross receipts under $15 million during the three preceding years.
Interest deductibility amendments included in the manager’s amendment include:
- Orrin Hatch (R-UT): Revises the “total equity” definition for worldwide interest limitation rule
- Rand Paul (R-KY): Allows full deductibility for motor vehicle floor plan financing (similar to the auto dealer carve-out in the House bill)
- Pat Roberts (R-KS): Treats agriculture/horticultural co-ops the same as other farming businesses for purposes of preserving full interest deductibility (similar to the agriculture co-op carve-out in the House bill)
- Sen. Pat Toomey (R-PA): Phases in the percentage used in determining excess indebtedness for purposes of the worldwide interest limitation rule
Pass-Through Tax Treatment
The House bill provides a 25 percent maximum rate for up to 30 percent of business income, with the remaining 70 percent taxed at personal rates (the lowest 9 percent rate applies to the first $75,000 in net business taxable income of an active owner or shareholder earning less than $150,000).
- Business owners could choose to categorize 70 percent of their income as wages, subject to ordinary rates, and 30 percent as business income, taxable at the 25 percent rate
- The alternative is to set the ratio of their wage income to business income based on the level of their capital investment
- Professional service firms, such as doctors, accountants and lawyers, couldn’t take the 70/30 split and could only avail themselves of the preferential rate based on capital investment
The Senate manager’s amendment increased the deduction for income of qualifying pass-through businesses from 17.4 percent (Senate Finance bill) to 23 percent at the request of Sens. Johnson (R-WI) and Daines (R-MT).
- This deduction is applicable to “qualified business income” derived from a pass-through corporation
- A “qualified business” is any trade or business other than a “specified service trade or business,” defined as “any trade or business activity involving the performance of services in section 1202(e)(3)(A), including investing and investment management, trading, or dealing in securities”
- Section 1202(e)(3)(A) defines “specified service trade or business” as “any trade or business activity involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business for which the principal asset is the reputation or skill of one or more of its employees
- If income is derived from a specified service trade or business, the taxpayer may still take the 23 percent deduction if the taxpayer’s income is $250,000 for individual or $500,000 for joint filers—or less
The House bill would require that assets be held for three years—instead of one—before a taxpayer could claim the special carried interest tax treatment.
- An applicable partnership interest means any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. Exceptions include:
- Any interest in a partnership directly or indirectly held by a corporation
- Any capital interest in the partnership that provides the taxpayer with a right to share in partnership capital commensurate with
- Amount of capital contributed (determined at the time of receipt of such partnership interest), or
- Value of such interest subject to tax under Section 83 upon the receipt or vesting of such interest
The Senate bill would impose a three-year holding period requirement for qualification as long-term capital gains with respect to certain partnership interests received in connection with the performance of services. This rule would apply to partnership distributions and dispositions of partnership interests.
- An applicable partnership interest would include any interest transferred, directly or indirectly, to a partner in connection with the performance of services by the partner, provided that the partnership is engaged in a trade or business conducted on a regular, continuous and substantial basis consisting of raising or returning capital and either (1) investing in, or disposing of, specified assets (or identifying specified assets for such investing or disposition); or (2) developing such specified assets
- For purposes of this provision, specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing
- Regulatory authority and anti-abuse rules are also provided
- Provision would be effective for tax years beginning after 2017
Unrelated Business Income Tax (UBIT)
Section 5001 of the House bill would amend Internal Revenue Code Section 511 to provide that, for unrelated business income tax purposes, “an organization or trust shall not fail to be treated as exempt from taxation under this subtitle for reason of Section 501(a) solely because such organization is also so exempt, or excludes amounts from gross income, by reason of any other provision of this title.”
- This language is being interpreted by many as subjecting all entities exempt from income tax under Section 501(a) (public pension plans) to the UBIT rules notwithstanding such entities’ exemption under any other provisions of the IRC
- Current law provides that income derived from trade or business carried on by an organization exempt from tax under IRC Section 501(a) that is not substantially related to the performance of the organization’s tax-exempt functions is subject to the UBIT. The Ways and Means Committee has said that it is unclear whether certain state and local entities (such as public pension plans) that are exempt under IRC Section 115(l) as government-sponsored entities, as well as Section 501(a), are subject to UBIT rules. Section 5001 of H.R. 1 amends IRC Section 511 to provide that an organization would not be exempt from the tax on UBIT solely because such an organization is also exempt from tax based on another IRC provision.
Section 13703 of the Senate bill would require any tax-exempt organization to calculate its UBIT liability on an activity-by-activity basis.
- As a result, such an organization would no longer be able to use the losses from one unrelated activity to offset income from a different unrelated activity
Government Shutdown Averted (for Now)
Congress passed a bill providing government funding for two weeks, Politico reports. As Republicans push for their tax reform bill, negotiations surrounding a budget deal have largely fallen by the wayside. Democrats claim they won’t back any comprehensive budget deal until a fix to Deferred Action for Childhood Arrivals, an Obama-era rule better known as DACA that allows children who are undocumented immigrants to be free from fear of deportation. In two weeks, Congress will have to pass another budget—while it will likely still be in the midst of tax reform talks.
Ben Marsico works on public policy issues for ACG.