01 May 2014 U.S. Tax Reform – Chairman Camp’s Discussion Draft: Business Taxation
Chairman Camp’s tax reform discussion draft gets the headline corporate tax rate down to the target rate of 25%, however the overall impact of the proposed reform would be an increased tax burden for businesses of around $580 billion.
Corporate tax rates in the U.S. are some of the highest in the developed world, however as a result of industry-specific deductions, many corporations boast a far lower effective tax rate. To get the headline rate down to 25%, Chairman Camp would eliminate many of these industry-specific deductions and, most controversially, would change the taxation of carried interest for pass-through entities.
General Business Changes
First, the draft proposal contains a number of changes to current depreciation and amortization methods. MACRS depreciation would be replaced with the Alternative Depreciation System which would increase asset lives and therefore decrease annual deductions. Bonus depreciation and certain accelerated depreciation classes would be repealed. The Section 179 deduction allowing businesses to expense certain asset purchases would be made permanent at $250,000 a year. Amortization of intangible assets under Section 197 would decrease by spreading the deductions over 20 years instead of the current 15 year period.
Industry specific deductions such as the Section 199 manufacturing deduction and the passive activity exception for working interests in the oil and gas industry would be eliminated. Research and development expenditures would need to be capitalized and amortized over 5 years, however the R&D tax credit would be made permanent.
There are a number of changes that would affect long-standing tax benefits for businesses and their owners. Sections 1045 and 1202 offering tax benefits to shareholders on the sale of small business stock would be repealed as would Section 1031 like-kind exchanges. The use of non-operating losses to offset income would be limited to 90% of the taxable income. Finally, 50% of advertising expenses over $1,000,000 in a tax year would have to be amortized over ten years instead of expensed in full.
Proposed accounting changes include the elimination of LIFO and lower of cost or market value inventory accounting. Taxpayers on the accrual method of accounting would have to recognize income in the year in which it is included in the financial statements, although cash accounting would be expanded to businesses with gross receipts under $10,000,000.
Banks would face a new quarterly excise tax of 0.035% on consolidated assets in excess of $500 billion.
Pass Through Entities
The draft proposal seeks to prevent the use of S corporations to avoid self-employment tax, as famously exploited by John Edwards and Newt Gingrich. Under current law, shareholders in S corporations do not pay self-employment tax on income of the S corporation that flows through to the shareholder. Under the proposal, a distributive share of S corporation income would be taxable as self-employment income, although taxpayers would be able to treat 30% of the compensation as a return of capital.
Probably the most controversial part of the tax reform proposal is the proposed change to the taxation of carried interest. Under the proposal, partnership interests held in connection with the performance of services would, at least in part, be taxed as ordinary income. A service partner’s share of the invested capital would be treated as generating ordinary income by multiplying the share by the specified rate of return (the Federal long-term rate plus 10%).
The draft proposes substantial reform of the U.S. international tax system and represents a shift to a more territorial system of taxation. Under the new system, 95% of dividends paid by foreign companies to 10% U.S. shareholders would be exempt from U.S. taxation. Transitional rules would cover the taxation of U.S. companies’ share of earnings and profits that have not yet been subject to U.S. taxation. The E&P consisting of cash would be taxed at 8.75%, while the balance would be taxed at 3.5%. Foreign tax credits would be available to offset this tax. The proposal eliminates the indirect foreign tax credit under Section 902.
The proposal also introduces a new type of foreign base company sales income—foreign base company intangible income (FBCII). FBCII would constitute the excess of the foreign company’s gross income over 10% of its adjusted basis in depreciable tangible property. The U.S. parent would be entitled to a deduction at a set percentage of the FBCII that relates to property sold for consumption outside the U.S. or services provided outside the U.S. The deduction percentage would start at 55% but would be phased down to 40% by 2019.
As with the changes to the taxation of individuals, the discussion draft would eliminate the vast majority of preferential deductions and credits. Even with the rate decrease to 25%, Chairman Camp’s discussion draft would represent a substantial increase to the businesses’ tax burden and will likely face resistance both from corporate interest groups and his own party.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.