1. Reduction in corporate tax rate (secs. 11 and 243 of the Code) and repeal of alternative minimum tax on corporations.
The bill eliminates the graduated corporate rate structure and instead taxes corporate taxable income at 21 percent. Special tax rates for personal service corporations are eliminated. The provision repeals the maximum corporate tax rate on net capital gain as obsolete.
The provision reduces the 70 percent dividends received deduction to 50 percent and the 80 percent dividends received deduction to 65 percent. This reduces the top tax rate on 70 percent dividends received is unchanged at 10.5%, and increases the top tax rate on 80% dividends received from 7% to 7.65%.
In addition, for taxpayers subject to the normalization method of accounting (e.g., regulated public utilities), the bill clarifies the normalization of excess tax reserves resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before the corporate rate reduction takes effect).
The special tax rates for capital gains of non-corporate taxpayers and qualified dividends are retained. So, the top federal tax rate on this income, including the Obamacare surtax when applicable, is 23.6%. Thus, the top combined corporate and shareholder level tax rate for C corporation profits realized at the shareholder level will be 39.644%, compared to the top rate on ordinary income of an individual subject to the Obamacare surtax of 40.6% (a 0.56 percentage point penalty). In contrast, under existing law, the top combined rate is 50.34% for C corporation profits realized at the shareholder level, compared to 43.2% for ordinary income of an individual subject to the Obamacare surtax (a 7.14 percentage point penalty).
The alternative minimum tax (AMT) for C corporations would also be repealed as it would otherwise undo many of the effects of the rate cut and other international tax provisions of the bill.
This is a 40% tax cut for businesses currently taxed as C corporations that pay any net income tax, predominantly large, publicly held companies. While economists argue over the incidence of the corporate income tax, the better view is that the corporate income tax falls almost entirely on shareholders of publicly held corporations, because there is no good reason for a corporation's CEO to drive a different bargain with third-parties (other, perhaps, than shareholders) because the tax rate applicable to corporate profits changes.
In the case of distributed income, the tax code is now very nearly neutral between income distributed as dividends and income distributed as interest, from C corporations, and new limitations on interest deductions for many industries will effectively make equity investment more desirable than debt investment from an aggregate tax impact perspective even in C corporations that hold combined interest and dividend distributions constant.
But, under the new law, the incentive to retain earnings to defer taxation of C corporation income remains even stronger. When the time value of money effect of partially deferring taxation of C corporation income is considered, on balance, equity is preferred over debt and the incentive of C corporations to raise funds by reinvesting income, relative to new offerings of debt or equity, will grow even stronger.
There is no total tax or tax deferral benefit for people in the 10% or 12% tax brackets. The 12% tax bracket tops out at $38,700 for individuals and $77,400 for joint filers of taxable income. But, after considering the standard deduction (which far more individuals will take under the new law), this works out to roughly $50,000 for individuals or $100,000 for joint filers. The benefits of a C corporation in deferring taxation on retained income area likely to be outweighed by the downsides of double taxation for people in the 22% and 24% tax brackets, the latter of which tops out at $157,500 for individuals and $315,000 for those filing jointly, which is also the threshold for the reduced taxation of self-employment income under the new law. Self-employed people with incomes under the threshold do not have a total tax or tax deferral benefit from shifting their self-employment income to a C corporation under the new law. The benefits of shifting self-employment income to a C corporation kick in only for those in the 32%, 35% and 37% tax brackets where there are tax deferral benefits in some cases, and even those are minimal for income above the threshold that still qualifies for the pass through entity tax break such as a great deal of rental income.
This is likely to drive down interest rates on bonds as fixed interest investors chase a declining supply of corporate bond issues (partially offset by increased rates on government bonds as the federal debt is increased and higher rates must be offered to encourage more people to buy Treasury bonds).
But, it is likely to cause stock prices to surge because stocks in publicly held companies will offer a great real world return that will not be offset completely by increased issuance of equity by publicly held companies.
Since these tax cuts overwhelmingly benefit the most affluent Americans and foreigners (who pay no U.S. shareholder level taxes at all on corporate profits), this tax cut will have a minimal impact on consumption that drives business, and will also have only a modest impact on investment because, as noted in part 5 of this series related to R&D amortization, U.S. companies are already sitting on record stockpiles of cash which they can't find worthwhile opportunities to invest as it is right now.
This tax cut address a problem, public corporations with insufficient access to investment capital, that is virtually non-existent at this moment in our nation's economic history.
This tax cut has been sold as an effort to address the relative top corporate tax rates of U.S. businesses v. those in other developed countries, but the U.S. was already one of the lowest taxed countries in the OECD on both a total taxation basis and on a corporate tax basis, once the impact of various corporate tax breaks such as NOL manipulation, R&D tax benefits, and tax avoidance measures in international commerce for multinational publicly held companies were considered.
So, this tax cut is likely to have a seriously harmful effect on the U.S. economy.
This tax cut will also have a dramatic impact on the organizational structure of U.S. businesses. As a general rule, it will make C corporations an attractive option to large numbers of small and medium sized businesses currently organized as LLC or S-corporations, although the relative desirability of C corporations is undercut by huge tax breaks for pass through enterprise businesses in this bill in a far more complex provision.
The bill's change to the C corporation tax rate does tend to reduce tax complexity, eliminating, for example, an entire cottage industry devised to utilize graduated tax rates in non-personal service corporations (and the need to distinguish between personal service corporations and non-personal service corporations), and the details of K-1s for entity owners which in a C corporation form of organization simply get a 1099 based upon the actual amount of dividends that shareholders receive broken into qualified and unqualified components. Similarly, simplification is achieved by eliminating all distinctions between capital gains and ordinary income for C corporations, or a tax rate incentive to shift income at the margins from one tax year to another in medium sized C corporations based upon differing graduated tax rates for the respective years. An end to NOL carry backs, while slightly tax increasing, also simplifies C corporation taxation.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: -1,388.8
This single provision accounts for about 93% of the tax cuts of the bill relative to the net effect of all of its other provisions.
2. Deduction for qualified business income (sec. 199A of the Code)
For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer generally may deduct 20 percent of qualified business income from a partnership, S corporation, or sole proprietorship, as well as 20 percent of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. Special rules apply to specified agricultural or horticultural cooperatives. A limitation based on W-2 wages paid and capital is phased in above a threshold amount of taxable income. A disallowance of the deduction with respect to specified service trades or businesses is also phased in above the threshold amount of taxable income.
Qualified business income
Qualified business income is determined for each qualified trade or business of the taxpayer. For any taxable year, qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. The determination of qualified items of income, gain, deduction, and loss takes into account these items only to the extent included or allowed in the determination of taxable income for the year. For example, if in a taxable year, a qualified business has $100,000 of ordinary income from inventory sales, and makes an expenditure of $25,000 that is required to be capitalized and amortized over 5 years under applicable tax rules, the qualified business income is $100,000 minus $5,000 (current-year ordinary amortization deduction), or $95,000. The qualified business income is not reduced by the entire amount of the capital expenditure, only by the amount deductible in determining taxable income for the year.
If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next taxable year. Similar to a qualified trade or business that has a qualified business loss for the current taxable year, any deduction allowed in a subsequent year is reduced (but not below zero) by 20 percent of any carryover qualified business loss.
Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the commonwealth of Puerto Rico, if all the income is taxable under section 1 (income tax rates for individuals) for the taxable year, the “United States” is considered to include Puerto Rico for purposes of determining the individual’s qualified business income.
Treatment of investment income
Qualified items do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include (1) any item taken into account in determining net long-term capital gain or net long-term capital loss, (2) dividends, income equivalent to a dividend, or payments in lieu of dividends, (3) interest income other than that which is properly allocable to a trade or business, (4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business, (5) the excess of foreign currency gains over foreign currency losses from section 988 transactions, other than transactions directly related to the business needs of the business activity, (6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets), and (7) any amount received from an annuity that is not used in the trade or business of the business activity. Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.
Reasonable compensation and guaranteed payments
Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.
Qualified trade or business
A qualified trade or business means any trade or business other than a specified service trade or business and other than the trade or business of being an employee.
Specified service business
A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (sections 475(c)(2) and 475(e)(2), respectively).
Phase-in of specified service business limitation
The exclusion from the definition of a qualified business for specified service trades or businesses phases in for a taxpayer with taxable income in excess of a threshold amount. The threshold amount is $157,500 (200 percent of that amount, or $315,000, in the case of a joint return) (the “threshold amount”). The threshold amount is indexed for inflation. The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). For a taxpayer with taxable income within the phase-in range, the exclusion applies as follows.
In computing the qualified business income with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages. The applicable percentage with respect to any taxable year is 100 percent reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return).
Tentative deductible amount for a qualified trade or business
For each qualified trade or business, the taxpayer is allowed a deductible amount equal to the lesser of 20 percent of the qualified business income with respect to such trade or business, so if the taxpayer’s taxable income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20 percent of the qualified business income with respect to each respective trade or business. This is subject to a wage and capital limitation above the threshold amount.
W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 wages do not include any amount which is not properly allocable to the qualified business income as a qualified item of deduction. In addition, W-2 wages do not include any amount which was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.
In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the commonwealth of Puerto Rico, if all the income is taxable under section 1 (income tax rates for individuals) for the taxable year, the determination of W-2 wages with respect to the taxpayer’s trade or business conducted in Puerto Rico is made without regard to any exclusion under the wage withholding rules52 for remuneration paid for services in Puerto Rico.
Phase-in of wage and capital limitation
The application of the wage and capital limitation phases in for a taxpayer with taxable income in excess of the threshold amount. The wage and capital limitation applies fully for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). The wage and capital limit applicable to taxpayers with taxable income above the threshold amount to provide a limit based either on wages paid or on wages paid plus a capital element. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.
For purposes of the provision, qualified property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (without regard to section 168(g)).
For example, a taxpayer (who is subject to the limit) does business as a sole proprietorship conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50 percent of W-2 wages, or $0, or (b) the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. The amount of the limitation on the taxpayer’s deduction is $2,500.
In the case of property that is sold, for example, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation. The Secretary is required to provide rules for applying the limitation in cases of a short taxable year of where the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the year. The Secretary is required to provide guidance applying rules similar to the rules of section 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W-2 wages and capital. Similarly, the Secretary shall provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W-2 wages and capital.
Qualified REIT dividends, cooperative dividends, and publicly traded partnership income.
A deduction is allowed under the provision for 20 percent of the taxpayer’s aggregate amount of qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income for the taxable year. Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend. A qualified cooperative dividend means a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount, provided it is includible in gross income and is received from either (1) a tax-exempt benevolent life insurance association, mutual ditch or irrigation company, cooperative telephone company, like cooperative organization,59 or a taxable or tax-exempt cooperative that is described in section 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter T of the Code in 1962. Qualified publicly traded partnership income means (with respect to any qualified trade or business of the taxpayer), the sum of the (a) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss (that are effectively connected with a U.S. trade or business and are included or allowed in determining taxable income for the taxable year and do not constitute excepted enumerated investment-type income, and not including the taxpayer’s reasonable compensation, guaranteed payments for services, or (to the extent provided in regulations) section 707(a) payments for services) from a publicly traded partnership not treated as a corporation, and (b) gain recognized by the taxpayer on disposition of its interest in the partnership that is treated as ordinary income (for example, by reason of section 751).
Determination of the taxpayer’s deduction
The taxpayer’s deduction for qualified business income for the taxable year is equal to the sum of (a) the lesser of the combined qualified business income amount for the taxable year or an amount equal to 20 percent of the excess of taxpayer’s taxable income over any net capital gain and qualified cooperative dividends, plus (b) the lesser of 20 percent of qualified cooperative dividends and taxable income (reduced by net capital gain). This sum may not exceed the taxpayer's taxable income for the taxable year (reduced by net capital gain). Under the provision, the 20-percent deduction with respect to qualified cooperative dividends is limited to taxable income (reduced by net capital gain) for the year. The combined qualified business income amount for the taxable year is the sum of the deductible amounts determined for each qualified trade or business carried on by the taxpayer and 20 percent of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income. The deductible amount for each qualified trade or business is the lesser of (a) 20 percent of the taxpayer's qualified business income with respect to the trade or business, or (b) the greater of 50 percent of the W-2 wages with respect to the trade or business or the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.
Treatment of agricultural and horticultural cooperatives
A deduction is allowed to any specified agricultural or horticultural cooperative equal to the lesser of (a) 20 percent of the cooperative’s taxable income for the taxable year or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. A specified agricultural or horticultural cooperative is an organization to which subchapter T applies that is engaged in (a) the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, (b) the marketing of agricultural or horticultural products that its patrons have so manufactured, produced, grown, or extracted, or (c) the provision of supplies, equipment, or services to farmers or organizations described in the foregoing.
Treatment of trusts and estates
The bill provides that trusts and estates are eligible for the 20-percent deduction under the provision. Rules similar to the rules under present-law section 199 (as in effect on December 1, 2017) apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital.
Special rules and definitions
For purposes of the provision, taxable income is determined without regard to the deduction allowable under the provision.
In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner takes into account the partner’s allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the partner’s allocable share of W-2 wages of the partnership. The partner’s allocable share of W-2 wages is required to be determined in the same manner as the partner’s share of wage expenses. For example, if a partner is allocated a deductible amount of 10 percent of wages paid by the partnership to employees for the taxable year, the partner is required to be allocated 10 percent of the W-2 wages of the partnership for purposes of calculating the wage limit under this deduction. Similarly, each shareholder of an S corporation takes into account the shareholder’s pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the shareholder’s pro rata share of W-2 wages of the S corporation.
Qualified business income is determined without regard to any adjustments prescribed under the rules of the alternative minimum tax.
The deduction under the provision is allowed only for Federal income tax purposes.
The 20-percent deduction is not allowed in computing adjusted gross income, and instead is allowed as a deduction reducing taxable income. Thus, for example, the provision does not affect limitations based on adjusted gross income.
The deduction is available to both nonitemizers and itemizers.
For purposes of determining a substantial underpayment of income tax under the accuracy related penalty, a substantial underpayment exists if the amount of the understatement exceeds the greater of five percent (not 10 percent) of the tax required to be shown on the return or $5,000.
Authority is provided to promulgate regulations needed to carry out the purposes of the provision, including regulations requiring, or restricting, the allocation of items of income, gain, loss, or deduction, or of wages under the provision. In addition, regulatory authority is provided to address reporting requirements appropriate under the provision, and the application of the provision in the case of tiered entities.
The provision does not apply to taxable years beginning after December 31, 2025.
This deserves a recap.
For people below the $157,500 ($315,000 for joint filers) threshold, which coincides with the top of the 24% individual income tax bracket under the new law (considered before the effect of this deduction), all income from Schedule C or a K-1 that is not "investment income" (such as long term capital gains, dividend income, or investment interest income) or a "guaranteed payment" (e.g. a salary or the equivalent) is reduced by 20% in the form of a deduction that is computed after adjusted gross income, but is still available to non-itemizers, limited to taxable income (but for the deduction) at most. Rent and short-term capital gains do not count as business income, so for some taxpayers, short term capital gains may actually be taxed at a lower rate than long term capital gains.
For people in the range $157,500-$207,500 ($315,000-$415,000 for joint filers), limitations based upon W-2 wages paid by the trade or business (50% if not capital investment is considered or 25% of capital investment is considered) and capital investments of the business (2.5% of acquisition basis where considered) is phased in, as is an exclusion for certain service based industries.
For people above $207,500 ($415,000 for joint filers) the W-2 wage and capital limitation, and the service based industry trade and business exclusion are completely excluded.
Basically, self-employed working class and middle class people have a 20% cut in their self-employment income, relative to employees starting in the 2018 tax year. The reduction will also apply to the non-investment business income of affluent people outside the service industries where there are significant W-2 wages paid or a significant amount of property that can be depreciated.
On the other hand, this tax break only reduces federal income taxation. In most cases, federal self-employment taxation (at 15.3% of self-employment income after an adjustment for the employer/employee split in FICA taxation) is a much heavier burden on working class and middle class people who are self-employed than federal income taxes, and self-employment taxation is not changed at all.
This dramatically increases tax complexity for a group of people with already complex tax returns. A huge amount of time and effort will be devoted to the dead weight loss of tax planning in an area of the law that previously was pretty close to a hypothetical ideal for tax fairness.
This official revenue impact probably drastically underestimates the extent to which employment income will be converted to self-employment income, which is often easy to do, and which once it happens, also undermines the integrity of the withholding tax regime. Tax complexity for those who transition from being employees to being self-employed with increase dramatically.
There is really no policy justification for favoring business profits over employment income, service income, and other forms of investment income. It distorts the economy away from some investments and activities and towards other investments and activities in an arbitrary way.
And, while the benefit of this provision is less regressive than the benefits of the cut in the corporate tax rate, it still skews towards those with higher income.
Ultimately, this provision is probably, on balance, seriously damaging to the U.S. economy and is likely to reduce economic growth.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: -414.5
3. Repeal of deduction for income attributable to domestic production activities (sec. 199 of the Code)
The provision repeals the deduction for income attributable to domestic production activities.
This provision was designed to encourage domestic manufacturing over imports, but was devised with an over broad definition of "domestic production activities" and didn't provide enough of a benefit to the targeted industries have much of an impact, while adding immensely to the complexity of tax returns in all manner of activities from cafes to auto plants, and creating static in trade negotiations. Eliminating it is unlikely to significantly harm any part of the U.S. economy, and most industries losing this tax break gain new tax breaks under the bill.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 98.0
4. Recharacterization of certain gains in the case of partnership profits interests held in connection with performance of investment services (secs. 1061 and 83 of the Code)
The provision provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. A three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer, notwithstanding the rules of section 83 (relating to property transferred in connection with performance of services) or any election in effect under section 83(b). The fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest, or that an individual may have made a section 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest. Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.
Short-term capital gain
The provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.
A special rule provides that, as provided in regulations or other guidance issued by the Secretary, this rule does not apply to income or gain attributable to any asset that is not held for portfolio investment on behalf of third party investors. Third party investor means a person (1) who holds an interest in the partnership that is not property held in connection with an applicable trade or business (defined below) with respect to that person, and (2) who is not and has not been actively engaged in directly or indirectly providing substantial services for the partnership or any applicable trade or business (and is (or was) not related to a person so engaged). A related person for this purpose is a family member (within the meaning of attribution rules) or colleague, that is a person who performed a service within the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.
Applicable partnership interest
An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with performance of services in any applicable trade or business. The services may be performed by the taxpayer or by any other related person or persons in any applicable trade or business. It is intended that partnership interests shall not fail to be treated as transferred or held in connection with the performance of services merely because the taxpayer also made contributions to the partnership, and the Treasury Department is directed to provide guidance implementing this intent. An applicable partnership interest does not include an interest held by a person who is employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to the other entity.
An applicable partnership interest does not include an interest in a partnership directly or indirectly held by a corporation. For example, if two corporations form a partnership to conduct a joint venture for developing and marketing a pharmaceutical product, the partnership interests held by the two corporations are not applicable partnership interests.
An applicable partnership interest does not include any capital interest in a partnership giving the taxpayer a right to share in partnership capital commensurate with the amount of capital contributed (as of the time the partnership interest was received), or commensurate with the value of the partnership interest that is taxed under section 83 on receipt or vesting of the partnership interest. For example, in the case of a partner who holds a capital interest in the partnership with respect to capital he or she contributed to the partnership, if the partnership agreement provides that the partner’s share of partnership capital is commensurate with the amount of capital he or she contributed (as of the time the partnership interest was received) compared to total partnership capital, the partnership interest is not an applicable partnership interest to that extent.
Applicable trade or business
An applicable trade or business means any activity (regardless of whether the activity areconducted in one or more entities) that consists in whole or in part of the following: (1) raising or returning capital, and either (2) investing in (or disposing of) specified assets (or identifying specified assets for investing or disposition), or (3) developing specified assets.
Developing specified assets takes place, for example, if it is represented to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with or at the direction of a service provider. Services performed as an employee of an applicable trade or business are treated as performed in an applicable trade or business for purposes of this rule. Merely voting shares owned does not amount to development; for example, a mutual fund that merely votes proxies received with respect to shares of stock it holds is not engaged in development.
Under the provision, specified assets means securities (generally as defined under rules for mark-to-market accounting for securities dealers), commodities (as defined under rules for mark-to-market accounting for commodities dealers), real estate held for rental or investment,
cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents, as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing. A security for this purpose means any (1) share of corporate stock, (2) partnership interest or beneficial ownership interest in a widely held or publicly traded partnership or trust, (3) note, bond, debenture, or other evidence of indebtedness, (4) interest rate, currency, or equity notional principal contract, (5) interest in, or derivative financial instrument in, any such security or any currency (regardless of whether section 1256 applies to the contract), and (6) position that is not such a security and is a hedge with respect to such a security and is clearly identified. A commodity for this purpose means any (1) commodity that is actively traded, (2) notional principal contract with respect to such a commodity, (3) interest in, or derivative financial instrument in, such a commodity or notional principal contract, or (4) position that is not such a commodity and is a hedge with respect to such a commodity and is clearly identified. For purposes of the provision, real estate held for rental or investment does not include, for example, real estate on which the holder operates an active farm.
A partnership interest, for purposes of determining the proportionate interest of a partnership in any specified asset, includes any partnership interest that is not otherwise treated as a security for purposes of the provision (for example, an interest in a partnership that is not widely held or publicly traded). For example, assume that a hedge fund acquires an interest in an operating business conducted in the form of a non-publicly traded partnership that is not widely held; the partnership interest is a specified asset for purposes of the provision.
Transfer of applicable partnership interest to related person If a taxpayer transfers any applicable partnership interest, directly or indirectly, to a person related to the taxpayer, then the taxpayer includes in gross income as short-term capital gain so much of the taxpayer’s net long-term capital gain attributable to the sale or exchange of an asset held for not more than three years as is allocable to the interest. The amount included as short-term capital gain on the transfer is reduced by the amount treated as short-term capital gain on the transfer for the taxable year under the general rule of the provision (that is, amounts are not double-counted). A related person for this purpose is a family member (within the meaning of attribution rules) or colleague, that is a person who performed a service within the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.
The Secretary is directed to require reporting (at the time in the manner determined by the Secretary) necessary to carry out the purposes of the provision. The penalties otherwise applicable to a failure to report to partners under section 6031(b) apply to failure to report under this requirement.
The Treasury Department is directed to issue regulations or other guidance necessary to carry out the provision. Such guidance is to address prevention of the abuse of the purposes of the provision, including through the allocation of income to tax-indifferent parties. Guidance is also to provide for the application of the provision in the case of tiered structures of entities.
This is a somewhat half-hearted attempt to close the "carried interest loophole" by which compensation of managers of private equity funds in the form of a percentage interest in the company received for services rather than an investment is treated as a capital gain rather than ordinary income. It requires a three year holding period for the carried interest capital gains tax treatment to apply, which is at most a minor tweak in most private equity fund compensation arrangements that doesn't address the basic issue that most of the earnings of private equity fund managers which are solely in exchange for services are taxes at a rate lower than that of working class wage earning employees.
Because it is largely ineffectual the bill has little or no economic impact.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.1
5. Repeal of rollover of publicly traded securities gain into specialized small business investment companies (sec. 1044 of the Code)
The bill repeals the election to roll over tax-free capital gain realized on the sale of publicly-traded securities.
This tax break was never very popular, in part, because capital gains were already lightly taxed and in part because the qualifications to use it were strictly limited. A similar provision, call Opportunity Zones, with a new politician's reputation attached to it replaces it.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.7
6. Opportunity zones (new secs. 1400Z-1 and 1400Z-2 of the Code)
The provision provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund.
Such designated areas were referred to as empowerment zones, the District of Columbia Enterprise (“DC”) Zone, and the Gulf Opportunity (“GO”) Zone, and each of these designations and attendant tax incentives have expired. The designations and tax incentives for the DC Zone, and the GO Zone generally expired after December 31, 2011. 1400(f), 1400N(h), 1400N(c)(5), 1400N(a)(2)(D), 1400N(a)(7)(C), 1400N(d). The empowerment zones program and attendant tax incentives expired as of December 31, 2016. Secs. 1391(d)(1), There are also areas that were designated as renewal communities under section 1400E which received tax benefits that all expired as of December 31, 2009, except that a zero-percent capital gains rate applies with respect to gain from the sale through December 31, 2014 of a qualified community asset acquired after December 31, 2001, and before January 1, 2010 and held for more than five years. For more information on these programs and attendant tax incentives, see Joint Committee on Taxation, Incentives for Distressed Communities: Empowerment Zones and Renewal Communities (JCX-38-09), October 5, 2009.
The provision allows for the designation of certain low-income community population census tracts as qualified opportunity zones, where low-income communities are defined in Section 45D(e). The designation of a population census tract as a qualified opportunity zone remains in effect for the period beginning on the date of the designation and ending at the close of the tenth calendar year beginning on or after the date of designation.
Governors may submit nominations for a limited number of opportunity zones to the Secretary for certification and designation. If the number of low-income communities in a State is less than 100, the Governor may designate up to 25 tracts, otherwise the Governor may designate tracts not exceeding 25 percent of the number of low-income communities in the State. Governors are required to provide particular consideration to areas that: (1) are currently the focus of mutually reinforcing state, local, or private economic development initiatives to attract investment and foster startup activity; (2) have demonstrated success in geographically targeted development programs such as promise zones, the new markets tax credit, empowerment zones, and renewal communities; and (3) have recently experienced significant layoffs due to business closures or relocations. The he mayor of the District of Columbia may also submit nominations and the District of Columbia counts as State for this purpose. Each population census tract in each U.S. possession that is a low-income community is deemed certified and designated as a qualified opportunity zone effective on the date of enactment.
The provision provides two main tax incentives to encourage investment in qualified opportunity zones.
First, it allows for the temporary deferral of inclusion in gross income for capital gains that are reinvested in a qualified opportunity fund. A qualified opportunity fund is an investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90 percent of its assets in qualified opportunity zone property. The provision intends that the certification process for a qualified opportunity fund will be done in a manner similar to the process for allocating the new markets tax credit. The provision provides the Secretary authority to carry out the process.
If a qualified opportunity fund fails to meet the 90 percent requirement and unless the fund establishes reasonable cause, the fund is required to pay a monthly penalty of the excess of the amount equal to 90 percent of its aggregate assets, over the aggregate amount of qualified opportunity zone property held by the fund multiplied by the underpayment rate in the Code. If the fund is a partnership, the penalty is taken into account proportionately as part of each partner’s distributive share.
Qualified opportunity zone property includes: any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
The maximum amount of the deferred gain is equal to the amount invested in a qualified opportunity fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. For amounts of the capital gains that exceed the maximum deferral amount, the capital gains must be recognized and included in gross income as under present law.
If the investment in the qualified opportunity zone fund is held by the taxpayer for at least five years, the basis on the original gain is increased by 10 percent of the original gain. If the opportunity zone asset or investment is held by the taxpayer for at least seven years, the basis on the original gain is increased by an additional 5 percent of the original gain. The deferred gain is recognized on the earlier of the date on which the qualified opportunity zone investment is disposed of or December 31, 2026. Only taxpayers who rollover capital gains of non-zone assets before December 31, 2026, will be able to take advantage of the special treatment of capital gains for non-zone and zone realizations under the provision.
The basis of an investment in a qualified opportunity zone fund immediately after its acquisition is zero. If the investment is held by the taxpayer for at least five years, the basis on the investment is increased by 10 percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, the basis on the investment is increased by an additional five percent of the deferred gain. If the investment is held by the taxpayer until at least December 31, 2026, the basis in the investment increases by the remaining 85 percent of the deferred gain.
The second main tax incentive in the bill excludes from gross income the post-acquisition capital gains on investments in opportunity zone funds that are held for at least 10 years. Specifically, in the case of the sale or exchange of an investment in a qualified opportunity zone fund held for more than 10 years, at the election of the taxpayer the basis of such investment in the hands of the taxpayer shall be the fair market value of the investment at the date of such sale or exchange. Taxpayers can continue to recognize losses associated with investments in qualified opportunity zone funds as under current law.
The Secretary or the Secretary’s delegate is required to report annually to Congress on the opportunity zone incentives beginning 5 years after the date of enactment. The report is to include an assessment of investments held by the qualified opportunity fund nationally and at the State level. To the extent the information is available, the report is to include the number of qualified opportunity funds, the amount of assets held in qualified opportunity funds, the composition of qualified opportunity fund investments by asset class, and the percentage of qualified opportunity zone census tracts designated under the provision that have received qualified opportunity fund investments. The report is also to include an assessment of the impacts and outcomes of the investments in those areas on economic indicators including job creation, poverty reduction and new business starts, and other metrics as determined by the Secretary.
Effective date.−The provision is effective on the date of enactment. There is no gain deferral available with respect to any sale or exchange made after December 31, 2026, and there is no exclusion available for investments in qualified opportunity zones made after December 31, 2026.
Like the myriad similar tax breaks adopted in the past, efforts to use federal tax breaks to encourage businesses to make long term capital investments in specified economically troubled geographic areas rarely work. The economic fundamentals overwhelm the tax benefits, because a tax break only helps if the underlying investment is profitable, and because it takes a great deal of specialized counsel to take advantage of the breaks.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: -1.6
7. Repeal of technical termination of partnerships (sec. 708(b) of the Code)
The provision repeals the section 708(b)(1)(B) rule providing for technical terminations of partnerships. The provision does not change the present-law rule of section 708(b)(1)(A) that a partnership is considered as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
This removes a gotcha provision in the tax code that sometimes cost ill advised partnerships and LLCs significant tax dollars. It slightly reduces tax complexity but has no major economic impact.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.6
8. Modification of the definition of substantial built-in loss in the case of transfer of partnership interest (sec. 743 of the Code)
The provision modifies the definition of a substantial built-in loss for purposes of section 743(d), affecting transfers of partnership interests. Under the provision, in addition to the present-law definition, a substantial built-in loss also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest.
For example, a partnership of three taxable partners (partners A, B, and C) has not made an election pursuant to section 754. The partnership has two assets, one of which, Asset X, has a built-in gain of $1 million, while the other asset, Asset Y, has a built-in loss of $900,000. Pursuant to the partnership agreement, any gain on sale or exchange of Asset X is specially allocated to partner A. The three partners share equally in all other partnership items, including in the built-in loss in Asset Y. In this case, each of partner B and partner C has a net built-in loss of $300,000 (one third of the loss attributable to asset Y) allocable to his partnership interest.
Nevertheless, the partnership does not have an overall built-in loss, but a net built-in gain of $100,000 ($1 million minus $900,000). Partner C sells his partnership interest to another person, D, for $33,333. Under the provision, the test for a substantial built-in loss applies both at the partnership level and at the transferee partner level. If the partnership were to sell all its assets for cash at their fair market value immediately after the transfer to D, D would be allocated a loss of $300,000 (one third of the built-in loss of $900,000 in Asset Y). A substantial built-in loss exists under the partner-level test added by the provision, and the partnership adjusts the basis of its assets accordingly with respect to D.
This closes a little known trick for trafficking in partnership losses, which is generally economically a good thing because it discourages tax gamesmanship that secured unintended tax benefits. But, the economic impact is modest since this loophole is rarely used.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 0.5
9. Charitable contributions and foreign taxes taken into account in determining limitation on allowance of partner’s share of loss (sec. 704 of the Code)
The provision modifies the basis limitation on partner losses to provide that the limitation takes into account a partner’s distributive share of partnership charitable contributions (as defined in section 170(c)) and taxes (described in section 901) paid or accrued to foreign countries and to possessions of the United States. Thus, the amount of the basis limitation on partner losses is decreased to reflect these items. In the case of a charitable contribution by the partnership, the amount of the basis limitation on partner losses is decreased by the partner’s distributive share of the adjusted basis of the contributed property. In the case of a charitable contribution by the partnership of property whose fair market value exceeds its adjusted basis, a special rule provides that the basis limitation on partner losses does not apply to the extent of the partner’s distributive share of the excess.
This closes a small accounting loophole in the charitable contributions and foreign tax credit amounts that partners can utilize. It is generally economically a good thing because it discourages tax gamesmanship that secured unintended tax benefits. But, the economic impact is modest since this loophole is rarely used.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.2
10. Charitable contribution deduction for electing small business trusts (sec. 642(c) of the Code)
The bill provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.
This slightly increases the amount of tax benefit that a trust holding S-corporation shares for an individual can take from a charitable deduction by the S-corporation.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: less than -0.3
11. Modification of tax treatment of Alaska Native Corporations and Settlement Trusts
(sec. 6039H and new secs. 139G and 247 of the Code)
The provision comprises three separate but related sections.
The first section allows a Native Corporation to assign certain payments described in ANCSA to a Settlement Trust without having to recognize gross income from those payments, provided the assignment is in writing and the Native Corporation has not received the payment prior to assignment. The Settlement Trust is required to include the assigned payment in gross income when received.
The second section allows a Native Corporation to elect annually to deduct contributions made to a Settlement Trust. If the contribution is in cash, the deduction is in the amount of cash contributed. If the contribution is property other than cash, the deduction is the amount of the Native Corporation’s basis in the contributed property (or the fair market value of such property, if less than the Native Corporation’s basis), and no gain or loss can be recognized on the contribution. The Native Corporation’s deduction is limited to the amount of its taxable income for that year, and any unused deduction may be carried forward 15 additional years. The Native Corporation’s earnings and profits for the taxable year are reduced by the amount of any deduction claimed for that year. Generally, the Settlement Trust must include income equal to the deduction by the Native Corporation. For contributions of property other than cash, the Settlement Trust takes a basis in the property equal to its basis in the hands of the Native Corporation immediately before the contribution (or the fair market value of such property, if less than the Native Corporation’s basis), and may elect to defer recognition of income associated with such property until the Settlement Trust sells or disposes of the property. In that case, any income that is deferred (i.e., the amount of income that would have been included upon contribution absent the election to defer) is treated as ordinary income, while any gain in excess of the amount that is deferred takes the same character as if the election had not been made. If property subject to this election is disposed of within the first taxable year subsequent to the taxable year in which the property was contributed to the Settlement Trust, the election is voided with respect to the property, and the Settlement Trust is required to pay any tax applicable to the disposition of the property, including interest, as well as a penalty of 10 percent of the amount of the tax. The provision provides for a four year assessment period in which to assess the tax, interest, and penalty amounts. The provision permits the amendment of the terms of any Settlement Trust agreement to allow this election within one year of the enactment of the provision, with certain restrictions.
The third section of the provision requires any Native Corporation which has made an election to deduct contributions to a Settlement Trust as described above to furnish a statement to the Settlement Trust containing: (1) the total amount of contributions; (2) whether such contribution was in cash; (3) for non-cash contributions, the date that such property was acquired by the Native Corporation and the adjusted basis of such property on the contribution date; (4) the date on which each contribution was made to the Settlement Trust; and (5) such information as the Secretary determines is necessary for the accurate reporting of income relating to such contributions.
Effective date.−The provision relating to the exclusion for ANCSA payments assigned to Settlement Trusts is effective to taxable years beginning after December 31, 2016. The provision relating to the deduction of contributions is effective for taxable years for which the Native Corporation’s refund statute of limitations period has not expired, and the provision provides a one-year waiver of the refund statute of limitations period in the event that the limitation period expires before the end of the one-year period beginning on the date of enactment. The provision relating to the reporting requirement applies to taxable years beginning after December 31, 2016.
This allows Alaska Native Corporation and Settlement Trusts to engage in tax free transactions with each other comparable to corporate reorganizations, which can streamline bureaucracy in an obscure corner of the tax code. It has a trivial but positive economic effect.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: -0.1
12. Modification of limitation on excessive employee remuneration ( sec. 162(m) of the Code)
Definition of covered employee
The provision revises the definition of covered employee to include both the principal executive officer and the principal financial officer. Further, an individual is a covered employee if the individual holds one of these positions at any time during the taxable year. The provision also defines as a covered employee the three (rather than four) most highly compensated officers for the taxable year (other than the principal executive officer or principal financial officer) who are required to be reported on the company’s proxy statement (i.e., the statement required pursuant to executive compensation disclosure rules promulgated under the Exchange Act) for the taxable year (or who would be required to be reported on such a statement for a company not required to make such a report to shareholders). This includes such officers of a corporation not required to file a proxy statement but which otherwise falls within the revised definition of a publicly held corporation, as well as such officers of a publicly traded corporation that would otherwise have been required to file a proxy statement for the year (for example, but for the fact that the corporation delisted its securities or underwent a transaction that resulted in the nonapplication of the proxy statement requirement).
In addition, if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual remains a covered employee for all future years. Thus, an individual remains a covered employee with respect to compensation otherwise deductible for subsequent years, including for years during which the individual is no longer employed by the corporation and years after the individual has died. Compensation does not fail to be compensation with respect to a covered employee and thus subject to the deduction limit for a taxable year merely because the compensation is includible in the income of, or paid to, another individual, such as compensation paid to a beneficiary after the employee’s death, or to a former spouse pursuant to a domestic relations order.
Definition of publicly held corporation
The provision extends the applicability of section 162(m) to include all domestic publicly traded corporations and all foreign companies publicly traded through ADRs. The proposed definition may include certain additional corporations that are not publicly traded, such as large private C or S corporations.
Performance-based compensation and commissions exceptions
The provision eliminates the exceptions for commissions and performance-based compensation from the definition of compensation subject to the deduction limit. Thus, such compensation is taken into account in determining the amount of compensation with respect to a covered employee for a taxable year that exceeds $1 million and is thus not deductible under section 162.
Effective date.−The provision applies to taxable years beginning after December 31, 2017. A transition rule applies to remuneration which is provided pursuant to a written binding contract which was in effect on November 2, 2017 and which was not modified in any material respect on or after such date. For purposes of the transition rule, compensation paid pursuant to a plan qualifies for this exception provided that the right to participate in the plan is part of a written binding contract with the covered employee in effect on November 2, 2017. For example, suppose a covered employee was hired by XYZ Corporation on October 2, 2017 and one of the terms of the written employment contract is that the executive is eligible to participate in the ‘XYZ Corporation Executive Deferred Compensation Plan’ in accordance with the terms of the plan. Assume further that the terms of the plan provide for participation after 6 months of employment, amounts payable under the plan are not subject to discretion, and the corporation does not have the right to amend materially the plan or terminate the plan (except on a prospective basis before any services are performed with respect to the applicable period for which such compensation is to be paid). Provided that the other conditions of the binding contract exception are met (e.g., the plan itself is in writing), payments under the plan are grandfathered, even though the employee was not actually a participant in the plan on November 2, 2017. The fact that a plan was in existence on November 2, 2017 is not by itself sufficient to qualify the plan for the exception for binding written contracts. The exception for remuneration paid pursuant to a binding written contract ceases to apply to amounts paid after there has been a material modification to the terms of the contract. The exception does not apply to new contracts entered into or renewed after November 2, 2017. For purposes of this rule, any contract that is entered into on or before November 2, 2017 and that is renewed after such date is treated as a new contract entered into on the day the renewal takes effect. A contract that is terminable or cancelable unconditionally at will by either party to the contract without the consent of the other, or by both parties to the contract, is treated as a new contract entered into on the date any such termination or cancellation, if made, would be effective. However, a contract is not treated as so terminable or cancelable if it can be terminated or cancelled only by terminating the employment relationship of the covered employee.
This provision tightens the limitations on cash compensation to CEOs and CFOs by expanding the kind of compensation that counts against the $1,000,000 limit to include commissions and performance bonuses and the scope of entities to which the limitation applies. Stock options are still excluded. On the whole recent economic scholarship has indicated that this provision had made executive compensation in large companies worse rather than better, so this provision has a negative economic impact.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 9.2
13. Treatment of qualified equity grants (sec 6051 of the Code)
The provision allows a qualified employee to elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to qualified stock transferred to the employee by the employer. An election to defer income inclusion (“inclusion deferral election”) with respect to qualified stock must be made no later than 30 days after the first time the employee’s right to the stock is substantially vested or is transferable, whichever occurs earlier.
If an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the taxable year that includes the earliest of (1) the first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer; (2) the date the employee first becomes an excluded employee (as described below); (3) the first date on which any stock of the employer becomes readily tradeable on an established securities market; (4) the date five years after the first date the employee’s right to the stock becomes substantially vested; or (5) the date on which the employee revokes her inclusion deferral election.
An inclusion deferral election is made in a manner similar to the manner in which a section 83(b) election is made. The provision does not apply to income with respect to nonvested stock that is includible as a result of a section 83(b) election. The provision clarifies that Section 83 (other than the provision), including subsection (b), shall not apply to RSUs. Therefore, RSUs are not eligible for a section 83(b) election. This is the case because, absent the inclusion deferral election and provide the employer with a copy. this provision, RSUs are nonqualified deferred compensation and therefore subject to the rules that apply to nonqualified deferred compensation.
An employee may not make an inclusion deferral election for a year with respect to qualified stock if, in the preceding calendar year, the corporation purchased any of its outstanding stock unless at least 25 percent of the total dollar amount of the stock so purchased is stock with respect to which an inclusion deferral election is in effect (“deferral stock”) and the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis. For purposes of this requirement, stock purchased from an individual is not treated as deferral stock (and the purchase is not treated as a purchase of deferral stock) if, immediately after the purchase, the individual holds any deferral stock with respect to which an inclusion deferral election has been in effect for a longer period than the election with respect to the purchased stock. Thus, in general, in applying the purchase requirement, an individual’s deferral stock with respect to which an inclusion deferral election has been in effect for the longest periods must be purchased first. A corporation that has deferral stock outstanding as of the beginning of any calendar year and that purchases any of its outstanding stock during the calendar year must report on its income tax return for the taxable year in which, or with which, the calendar year ends the total dollar amount of the outstanding stock purchased during the calendar year and such other information as the Secretary may require for purposes of administering this requirement.
A qualified employee may make an inclusion deferral election with respect to qualified stock attributable to a statutory option. In that case, the option is not treated as a statutory option and the rules relating to statutory options and related stock do not apply. In addition, an arrangement under which an employee may receive qualified stock is not treated as a nonqualified deferred compensation plan solely because of an employee’s inclusion deferral election or ability to make an election.
Deferred income inclusion applies also for purposes of the employer’s deduction of the amount of income attributable to the qualified stock. That is, if an employee makes an inclusion deferral election, the employer’s deduction is deferred until the employer’s taxable year in which or with which ends the taxable year of the employee for which the amount is included in the employee’s income as described in (1)-(5) above.
Qualified employee and qualified stock
Under the provision, a qualified employee means an individual who is not an excluded employee and who agrees, in the inclusion deferral election, to meet the requirements necessary (as determined by the Secretary) to ensure the income tax withholding requirements of employer corporation with respect to the qualified stock (as described below) are met. This requirement is met if the stock purchased by the corporation includes all the corporation’s outstanding deferral stock.
For this purpose, an excluded employee with respect to a corporation is any individual (1) who was a one-percent owner of the corporation at any time during the 10 preceding calendar years, (2) who is, or has been at any prior time, the chief executive officer or chief financial officer of the corporation or an individual acting in either capacity, (3) who is a family member of an individual described in (1) or (2), or (4) who has been one of the four highest compensated officers of the corporation for any of the 10 preceding taxable years.
Qualified stock is any stock of a corporation if an employee receives the stock in connection with the exercise of an option or in settlement of an RSU, and the option or RSU was granted by the corporation to the employee in connection with the performance of services and in a year in which the corporation was an eligible corporation (as described below).
However, qualified stock does not include any stock if, at the time the employee’s right to the stock becomes substantially vested, the employee may sell the stock to, or otherwise receive cash in lieu of stock from, the corporation. Qualified stock can only be such if it relates to stock received in connection with options or RSUs, and does not include stock received in connection with other forms of equity compensation, including stock appreciation rights or restricted stock.
A corporation is an eligible corporation with respect to a calendar year if (1) no stock of the employer corporation (or any predecessor) is readily tradable on an established securities market during any preceding calendar year, and (2) the corporation has a written plan under which, in the calendar year, not less than 80 percent of all employees who provide services to the corporation in the United States (or any U.S. possession) are granted stock options, or restricted stock units (“RSUs”), with the same rights and privileges to receive qualified stock (“80-percent requirement”). For this purpose, in general, the determination of rights and privileges with respect to stock is determined in a similar manner as provided under the present-law ESPP rules. However, employees will not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount, provided that the number of shares available to each employee is more than a de minimis amount. In addition, rights and privileges with respect to the exercise of a stock option are not treated for this purpose as the same as rights and privileges with respect to the settlement of an RSU.
For purposes of the provision, corporations that are members of the same controlled group are treated as one corporation. For purposes of determining corporations that are members of the same controlled group and treated as one corporation, the definition of controlled group under section 414(b) applies.
Notice, withholding and reporting requirements
Under the provision, a corporation that transfers qualified stock to a qualified employee must provide a notice to the qualified employee at the time (or a reasonable period before) the employee’s right to the qualified stock is substantially vested (and income attributable to the stock would first be includible absent an inclusion deferral election). The notice must (1) certify to the employee that the stock is qualified stock, and (2) notify the employee (a) that the employee may (if eligible) elect to defer income inclusion with respect to the stock and (b) that, if the employee makes an inclusion deferral election, the amount of income required to be included at the end of the deferral period will be based on the value of the stock at the time the employee’s right to the stock first becomes substantially vested, notwithstanding whether the value of the stock has declined during the deferral period (including whether the value of the stock has declined below the employee’s tax liability with respect to such stock), and the amount of income to be included at the end of the deferral period will be subject to withholding as provided under the provision, as well as of the employee’s responsibilities with respect to required withholding. Failure to provide the notice may result in the imposition of a penalty of $100 for each failure, subject to a maximum penalty of $50,000 for all failures during any calendar year.
An inclusion deferral election applies only for income tax purposes. The application of FICA and FUTA are not affected. The provision includes specific income tax withholding and reporting requirements with respect to income subject to an inclusion deferral election.
For the taxable year for which income subject to an inclusion deferral election is required to be included in income by the employee (as described above), the amount required to be included in income is treated as wages with respect to which the employer is required to withhold income tax at a rate not less than the highest income tax rate applicable to individual taxpayers. The employer must report on Form W-2 the amount of income covered by an inclusion deferral election (1) for the year of deferral and (2) for the year the income is required to be included in income by the employee. In addition, for any calendar year, the employer must report on Form W-2 the aggregate amount of income covered by inclusion deferral elections, determined as of the close of the calendar year.
(1) When an inclusion deferral election is made with respect to stock transferred under an ESPP, the option is not considered an ESPP, such that when an inclusion deferral election is made in connection with the exercise of both ESPPs and ISOs, the options are not treated as statutory options but rather as nonqualified stock options for FICA purposes (in addition to being subject to section 83(i) for income tax purposes), (2) an excluded employee includes an individual who first becomes a 1 percent owner or one of the 4 highest compensated officers in a taxable year, notwithstanding that such individual may not have been among such categories for the 10 preceding taxable years, (3) the requirement that 80 percent of all applicable employees be granted stock options or restricted stock units with the same rights and privileges cannot be satisfied in a taxable year by granting a combination of stock options and RSUs, and instead all such employees must either be granted stock options or be granted restricted stock units for that year, and (4) the exception from treatment as a nonqualified deferred compensation plan for purposes of section 409A applies solely with respect to an employee who may receive qualified stock. It is intended that the requirement that 80 percent of all applicable employees be granted stock options or be granted restricted stock units apply consistently to eligible employees, whether they are new hires or existing employees. The provision specifies that qualified stock is treated as a noncash fringe benefit for income tax withholding purposes. applicable regulations apply with respect to the determination of when stock first becomes transferrable or is no longer subject to a substantial risk of forfeiture. For example, income inclusion cannot be delayed due to a lock-up period as a result of an initial public offering. Finally, it is intended that the transition rule provided with respect to compliance with the 80-percent and employer notice requirements not be expanded beyond these specific items.
Effective date.−The provision generally applies with respect to stock attributable to options exercised or RSUs settled after December 31, 2017. Under a transition rule, until the Secretary (or the Secretary’s delegate) issues regulations or other guidance implementing the 80-percent and employer notice requirements under the provision, a corporation will be treated as complying with those requirements (respectively) if it complies with a reasonable good faith interpretation of the requirements. The penalty for a failure to provide the notice required under the provision applies to failures after December 31, 2017.
This provision provides a safe harbor way to compensate employees with stock as opposed to stock options that are not currently liquid, deferring taxation until the stock is liquid.
The economic impact is modest since it differs only moderately from existing options and isn't likely to be widely used.
The estimated dollar impact of this provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: -1.2