If Senate Democratic leaders have their way, they will vote this week on the American Jobs and Closing Tax Loopholes Act, which is an amended version of a bill passed in late May by the House (HR 4213).
This bill extends a long list of existing tax credits, deductions, and provisions, and makes changes to others. It also modifies the tax treatment of certain types of income in an attempt to significantly raise revenue to help pay for the extenders and various initiatives by the Obama administration.
While there is much agreement on most of the issues in this version of the bill, there also is some controversy. Democratic leaders are characterizing the bill as job-creation friendly, while fiscal conservatives from both parties are warning that the immense price tag of this legislation ($85 billion in additional deficit spending for the Senate bill, $60 billion for the House bill, according to the Congressional Budget Office) is troubling. As we await the final vote, here is a summary of the major components of the legislation.
The House and Senate versions both contain several measures that are dubbed revenue raisers, or spending offsets. Some of the key offsets are:
Carried interest occurs when a partner receives an interest in future profits in exchange for services. That income is taxed at capital gains rates. Both the House and Senate bills change the way carried interest will be taxed – that is, they treat carried interest as ordinary income to the extent of the partner’s qualified capital interest. The two bills differ in approach in the following areas:
- Part of the income that is recharacterized would be taxed at ordinary income rates, which, for tax years beginning before 2013, would be 50 percent.
- For tax years beginning after January 1, 2013, that rate increases to 75 percent.
- No industries would be exempt. This provision would be effective now, for tax years ending in 2010.
- This bill would tax the recharacterized income at 65 percent beginning after 2012.
- The rate would be reduced to 55 percent for gain or loss from the sale of assets held for at least seven years.
- For 2011 and 2012, the applicable tax rate would be 50 percent.
- The Senate bill also includes a controversial carve-out which exempts the recharacterized income from the sale of certain interests in energy-related public partnerships.
With the top ordinary income rate currently at 35 percent and the top capital gain rate currently at 15 percent, the tax hike would be enormous as it is. Plus, after 2011 the two ordinary income rates are expected to rise to 39.6 percent and 20 percent, respectively. In addition, ordinary income would be subject to self-employment taxes.
Both House and Senate bills address what some lawmakers see as evasion of employment tax by certain individuals. The Internal Revenue Service has stated that many taxpayers receive nominal salaries and take their earnings through distributions by S corps, limited partnerships, or other entities. Both the House and Senate bills attempt to plug this alleged loophole – thus raising significant revenue – by imposing self-employment payroll taxes on 100 percent of S-corp pass-through income when:
- The S-corp is engaged in a professional service business, with the key assets being the reputation and skill of no more than three employees
- The S-corp is a partner in a professional service business
Foreign Tax Credit Reforms
The foreign tax credit was intended to prevent double taxation on foreign-source income. But corporations have found ways to use the credit to inappropriately reduce the taxes they pay in the United States.
In an effort to end abuses involving foreign tax credits – that is, keeping foreign income untaxed while using foreign taxes to offset U.S. tax due on other foreign-source income – the House and Senate have adopted a matching rule that prevents the separation of creditable foreign taxes from the related foreign income. The bill contains various provisions which suspend the recognition of foreign tax credits until the associated foreign income is taxed in the U.S.
Here are some of the key provisions:
- Stock acquisitions that are treated as asset purchases generally qualify for a stepped-up basis. For foreign companies, the step-up cannot be used for foreign taxes, but only for U.S. taxes, in order to prevent taxpayers from claiming foreign tax credits against foreign income that was never taxed in the U.S.
- The foreign tax credit is limited to the top U.S. tax rate of 35 percent. The Obama administration states that some taxpayers are inflating foreign source income by using treaties to shift the source of some assets to their foreign branches. House and Senate reforms set aside this income so that it is not used to claim foreign tax credits.
Tax issues and extenders for individuals
The House and Senate bills generally are in agreement when it comes to the extension of provisions for individual taxpayers with the exception of the homebuyer credit and COBRA (see “Tax issues and extenders for business” below for COBRA information).
This first-time homebuyer credit for $8,000 (or $6,500 for long-time homebuyers) has been available to qualified taxpayers who bought homes before May 1, 2010, with the requirement that the home-purchase contracts close no later than June 30, 2010. In actuality, it was learned that many homebuyers underestimated the time needed to close escrow. To protect those taxpayers, the Senate proposes to extend the required closing date to September 30, 2010. However, this proposal might not survive the final bill. The House would like to see the credit expanded to include qualified purchases made through 2010 and closed by May 1, 2011.
The following provisions were set to expire on December 31, 2009, and are extended through 2010.They include:
State and local sales tax deduction. This provision has been in place since 2004, allowing taxpayers to take either an itemized deduction for state and local income taxes paid, or state and local general sales taxes.
Increased standard deduction for real estate taxes. This is for taxpayers who do not itemize. It allows them to claim an extra standard deduction or all or part of the state and local real estate taxes paid, up to $500 for single filers ($1,000 for joint filers).
Higher education tuition deduction. Before this provision expired on January 1, 2010, qualified taxpayers could take an above-the-line deduction for certain higher education tuition and related expenses. The maximum deduction of $4,000 was available to those taxpayers with adjusted gross income (AGI) not over $65,000 for single filers and $130,000 for joint filers. A reduced deduction of up to $2,000 was available for single filers with AGI up to $80,000 and joint filers up to $160,000.
Teacher’s classroom expense deduction. Allows teachers and other education professionals (kindergarten through 12th grade) to deduct qualified out-of-pocket expenses up to $250. In addition, taxpayers who itemize may be able to deduct the amounts that exceed $250 as employment-related miscellaneous itemized deductions, subject to the 2 percent floor.
Tax issues and extenders for business
Agreement on bonus depreciation has not yet been reached, but political observers expect Republicans to push for this provision before the final vote.
COBRA premium assistance, which lets eligible individuals pay only 35 percent of their COBRA premiums, and reimburses employers for the expense through a payroll tax credit – expired May 31, 2010. The House bill considered extending the COBRA program through November 30, 2010, but dropped this provision because of cost concerns. Twenty senators have expressed support for the extension, so its future in the Senate bill is uncertain.
Generally, the House and Senate are in agreement on the need to let most of the business extenders remain in force through 2010, including (but not limited to):
Research and experimentation. Because of the great importance of research and experimentation to the future of the American economy, there is a lot of support in the House and Senate for making this credit permanent. However, it also is the most costly provision on the table (over $6 billion). Therefore, it is currently extended only for the current year and will be addressed again in 2011.
Business property improvement credits.
- Business taxpayers can treat retail property improvements placed in service in 2010 as 15-year property under the Modified Accelerated Cost Recovery System (MACRS).
- Business taxpayers can treat restaurant property improvements placed in service in 2010 as 15-year property under MACRS.
- Qualified leasehold improvements have been subject to treatment as 15-year property under MACRs since 2004, thanks to previous extensions. This treatment requires the use of straight-line depreciation and the half-year convention unless the mid-year convention applies.
Refundable AMT credits. This credit allows business taxpayers to elect to apply 10 percent of unused AMT credits toward qualified investments in domestic manufacturing facilities and equipment.
Differential pay credit. Qualified small businesses (defined as having fewer than 50 employees) can take a 20 percent credit for differential wages paid to qualified employees called to military active duty, up to $20,000.
Indian employment credit. This is available for businesses that employ enrolled members of Native American Indian tribes, or their spouses; whose work is performed primarily on the tribe’s reservation; and who have their main homes on the reservation. The credit is equal to 20 percent of the excess of current wages and health insurance over those same costs paid in 1993. In general, the wages and insurance costs cannot exceed $20,000 per employee per year.
Environmental remediation. Businesses can elect to deduct the cost of environmental remediation in the year they are paid or incurred.
Film and television. Certain taxpayers can deduct the first $15 million in qualified production costs.
Charitable extenders. Up to the end of 2009, many provisions were available, designed to encourage donations to charitable causes. Each provision listed below expired on December 31, 2009, and has now been extended through 2010 by the House and Senate.
IRA contributions to charity. Allows individuals age 70 1/2 and over to give up to $100,000 from their IRAs to a charity, without recognizing it as income, and without being subject to contribution limits.
Real property contributions for conservation purposes. These are subject to the existing limitations on the aggregate of conservation contributions.
Contributions of food inventory. Donations must be of apparently wholesome food, for human consumption, and meeting all applicable regulatory standards.
Contributions of book inventory to public schools. As before, the book inventory deduction is not available to S-corporations.
Computer inventory, by a corporation, for educational purposes. The deduction is equal to the donor’s basis in the donated property, plus one-half of the ordinary income that would have been realized by selling the property.
S-corporation charitable contributions. For shareholders in S-corporations who make charitable contributions, the shareholder’s basis in stock is reduced by his or her pro rata share of the adjusted basis of contributed property. This provision has been in place since 2005.
Controlling exempt organizations. The special rules for interest, rent, royalties, and annuities received by an exempt entity from a controlled entity are extended.
A large number of energy credits have been extended by both the House and Senate. Members of Congress say that, if these credits had been renewed earlier this year, many jobs in the energy industry would have been preserved. The major energy credits include:
Alternative motor vehicle credit for heavy hybrids. There are separate credits available for cars and light, medium, and heavy trucks. The expiration date of the credit depends on the vehicle type. The credit might have been set to expire after 2009, 2010, or 2014, but are all extended for one year, respectively.
Biodiesel. These credits and payment provisions are for biodiesel, biodiesel small producers, and a biodiesel excise credit.
Alternative fuels. Credits and payment provisions are available for alternative fuel production, for compressed and liquefied natural gas, and liquefied petroleum gas
Sales of electric utility property. Certain sales of electric transmission property can result in deferred gain for up to eight years. The sale must be to a qualified independent transmission company and the proceeds must be reinvested in production of certain natural gas or electricity. The provision to defer gains is extended through 2010.
Other energy provisions: Miscellaneous modifications were made to residential energy property credits, but the expiration date was not extended. For 2009 and 2010, individuals are permitted a 30 percent credit (up to a maximum of $1,500) for installing energy-efficient exterior windows, doors, skylights, heating and air conditioning systems, insulation, water heaters, roofs, and biomass stoves. The House and Senate did modify the credit by making eligibility dependent on meeting Energy Star standards.
In light of the Gulf oil spill, the extension of oil and gas tax preferences is vulnerable at this time. Congress is considering the repeal of these preferences as a source to fund other programs, such as another COBRA premium extension or first-time homebuyer assistance.
Several infrastructure incentives are extended and modified by both the House and Senate bills, which include:
- Addition of a new market tax credit, which grants a 39 percent total federal tax credit over seven years to taxpayers who make qualifying investments in community development entities. The investments must be made on or after March 15, 2010, through the end of 2010.
- Enhancements to the Build America Bonds program.
- Extension of tax-exempt eligibility for loans guaranteed by Federal Home Loan Banks.
- Extension of temporary small issuer rules for allocation of tax exempt interest expense, through 2011.
National disaster relief
National disaster relief is enacted as disasters occur. But the general treatment of disaster losses was addressed in the House and Senate bills. Previously, the 10 percent AGI limitation that applies to personal casualty loss deductions was waived for personal net disaster losses. This waiver expired after 2009. The House and Senate bills extend the waiver through 2010.
Other legislation relating to national disaster relief includes the following extensions through 2010:
- Bonus depreciation – The additional 50 percent bonus depreciation on property that replaces or rehabilitates property damaged in a federally declared disaster.
- One non-friendly provision for taxpayers – The amount by which taxpayers who are claiming casual losses must reduce their personal casualty loss from each casualty was increased from $100 to $500, for tax years beginning in 2008.
- Businesses that must engage in disaster clean up and repair relative to a qualified disaster currently can deduct rather than capitalize those expenses.
- NOL carry-back – Net operating losses may be carried back five years for qualified federally declared disaster losses.
Pension funding relief
Both the House and Senate Bills include several measures to provide relief in the form of eased funding rules for single and multiple employer pension plans. Here are some of the key changes:
Defined benefit plans are currently subject to minimum funding rules which include annual employer contributions to fund the plan benefits.
Single-employer plans –When single employer plans are underfunded, the shortfall is to be amortized in equal installments over seven years, beginning with the current year. Both bills offer two alternative plans:
- Single employer plans may amortize the shortfall over nine years, which requires interest-only payments in the first two years, followed by seven level installments.
- Or amortize over 15 years of level installments, beginning with the election year. Plan sponsors can opt for a relief plan in up to two plan years in 2008-2011.
Multi-employer plans – Plans to which more than one employer contributes under a collective bargaining agreement currently must amortize net experience losses over 15 years. Both the House and Senate bills would allow these plans to choose a 30-year amortization period for certain losses incurred in one of the first two plan years ending on or after June 30, 2008.
Both bills also extend the five-year smoothing period for determining plan asset values to 10 years for the same two years above.
As Congress tries to wrap up the vote on this legislation which they have said is critical to job creation, it’s unclear whether the House will adopt the Senate version, or the Senate will try to reconcile the differences. According to the latest timetable provided, Congress hopes to vote on a final bill before the end of this week.