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Tax Provisions in the Administration’s Fiscal Year 2016 Budget

June 30, 2015

By the WeiserMazars Tax Practice Board

President Obama’s proposed 2016 budget contains new provisions as well as some from previous budgets – it includes plans to revise the U.S. international tax system, the taxation of domestic corporations and provisions affecting individuals. We will briefly cover some of the proposals affecting both corporations and individuals.

Provisions Affecting Individuals

Long Term Capital Gains and Qualified Dividends Tax Rate

The President’s proposal would increase the tax rate on long term capital gains and qualified dividends to 24.2% from 20%. The 3.8% net investment income tax would continue to apply, thus increasing the top effective long term capital gains and qualified dividends rate to 28%.

Implementation of the Buffett Rule

President Obama has included the so-called “Buffet Rule,” calling it the Fair Share Tax. The proposal would impose a new minimum tax of30 percent of adjusted gross income (AGI) less a credit for charitable contributions, subject to certain limitations. It would begin phasing in linearly for taxpayers having $1 million of AGI ($500,000 if married filing separately), and be fully phased in at $2 million of AGI ($1 million if married filing separately).

Reduction in the Value of Itemized Deductions and Other Items

President Obama’s budget proposal would limit the value of itemized deductions to 28 percent. It would also limit the value of specified deductions or exclusions from AGI, such as tax exempt state and local bond interest and employer sponsored health insurance paid for by employers, to 28 percent. A similar limitation would also apply under the alternative minimum tax.

Carried Interest Taxation

The budget proposal would tax income from a carried interest held by a person who provides services to the partnership as ordinary income regardless of its characterization at the partnership level. It would also subject the income to self-employment tax. Currently, income from carried interests is often taxed as long term capital gains, depending on the income generated by the trading or investment partnership. In addition, it is currently not subject to self-employment tax.

Modification of Estate and Gift Tax Provisions

The President’s proposal would treat a gift or bequest of appreciated property as a sale of the property. Consequently, the donor or decedent would realize a capital gain at the time of the gift or bequest. This change would eliminate the income tax free nature of a gift and the stepped up basis for appreciated assets at death. Gains on certain property would be excludable and each person would be allowed to exclude $100,000 (indexed for inflation) of other capital gains recognized by reason of death.

It would also restore the gift, estate and generation skipping transfer tax rates and exemptions to their 2009 levels. Accordingly, the gift, estate and generation skipping transfer tax rate would increase to 45% from its current 40%. The estate and generation skipping transfer tax exemption would decrease to $3.5 million (not indexed for inflation) from $5.43 million while the gift tax exemption would decrease to $1 million from $5.43 million.

Modify Transfer Tax Rules for Grantor Retained Annuity Trusts (GRATS) and Other Grantor Trusts

The administration’s proposal would require that a GRAT have a minimum term of 10 years, a maximum term equal to the life expectancy of the annuitant plus 10 years, and prohibit any decrease in the annuity during the GRAT term. In addition, the remainder interest would be required to have a value equal to the greater of 25% of the value of the assets contributed to the GRAT or $500,000 (but not more than the value of the assets contributed to the trust) at the time the interest is created. It would also prohibit the grantor from engaging in tax-free exchanges of trust assets.

Additionally, with respect to sales of assets to a grantor trust of which the seller is the deemed owner for income tax purposes, the portion of the trust attributable to the property received by the trust in the transaction would be subject to estate tax at the seller’s death or gift tax when the seller is no longer considered the deemed owner. The amount subject to transfer tax would be reduced by any portion of that amount that was treated as a prior taxable gift.

Simplify Gift Tax Exclusion for Annual Gifts

The President’s proposal would eliminate the gift tax annual exclusion’s present interest requirement with respect to certain gifts and impose an annual limit per donor of $50,000 (indexed for inflation) on transfers of property within a new category which would include transfers in trust (other than to a trust described in section 2642(c)(2)); transfers of interests in pass through entities; transfers entirely subject to a prohibition on sale; and, other transfers of property that, without regard to withdrawal, put, or other such rights, in the donee, cannot immediately be liquidated by the donee.

Limit Duration of Generation-Skipping Transfer (GST) Tax Exemption

Many trusts are now formed in jurisdictions that do not contain a rule against perpetuity which means the trust can continue indefinitely. These trusts are oftentimes fully exempt from GST tax. The proposal would provide that, on the 90th  anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate.

Individual Retirement Accounts

The budget proposal would require employers in business for at least two years that have more than ten employees to offer an automatic IRA option to employees. Certain exceptions would apply. Small employers would be entitled to claim a temporary nonrefundable tax credit for the employer’s expense associated with the arrangement and would be entitled to an additional nonrefundable credit per enrolled employee for a period of six years.

Simplify Minimum Required Distribution (MRD) Rules

The proposal would exempt an individual from the MRD requirements if the aggregate value of the individual’s IRA and tax-favored retirement plan accumulations does not exceed $100,000. The MRD requirements would phase in for individuals with aggregate retirement benefits between $100,000 and $110,000.

In addition, the proposal would unify the application of the MRD requirements for holders of designated Roth accounts and Roth IRAs by generally treating Roth IRAs in the same manner as all other tax-favored retirement accounts.

Require Non-Spouse Beneficiaries of Deceased IRA Owners and Retirement Plan Participants to Take Inherited Distributions Over No More Than Five Years.

Currently, minimum distributions from a retirement plan or IRA paid to a non-spouse beneficiary can be taken over the beneficiary’s lifetime in certain situations and are required to be distributed based on the joint life expectancy of the participant or employee and a designated beneficiary. Under the President’s proposal, non-spouse beneficiaries of retirement plans and IRAs would generally be required to take distributions over no more than five years. Exceptions would apply to certain “eligible beneficiaries” for whom distributions would be allowed over the life or life expectancy of the beneficiary beginning in the year following the year of the death of the participant or owner. In the case of a child, the account would need to be fully distributed no later than five years after the child reaches the age of majority.

Extend Exclusion from Income for Cancellation of Certain Home Mortgage Debt

Gross income generally includes income realized from the discharge of indebtedness. Currently, there is an exception for debt on a principal residence, which generally is acquisition indebtedness limited to $2 million ($1 million if married filing separately). Under this exception, taxpayers are allowed to exclude income from the discharge of principal residence debt. Discharge of principal residence debt includes full and partial reductions of the debt. The proposal would extend the exclusion from income to amounts that are discharged before January 1, 2018.

Tax Benefits for Education

In an attempt to simplify the tax benefits available to offset higher education costs, President Obama proposes to eliminate the Lifetime Learning Credit and student loan interest deduction and replace them with an expanded American Opportunity Tax Credit (AOTC). The AOTC would be available for a longer period of time, undergraduate students who attend school less than half-time would be eligible, and a larger portion of the credit would be refundable.

Reform of Child Care Tax Incentives

The budget calls for the expansion of the Child and Dependent Care Credit. The maximum credit for taxpayers with children under age five would increase from $1,050 to $3,000 per child. The income levels at which the credit begins to phase down would be increased. In addition, the dependent care flexible spending account would be eliminated.

Provisions Affecting Corporations

The most discussed changes proposed by the administration include modifications to the U.S. international tax system. The modifications summarized below form the administration’s primary efforts to reduce taxpayers’ ability to shift income overseas.

Imposition of a 19% Minimum Tax on Foreign Earnings of Controlled Foreign Corporations and a One-Time 14% Transition Tax

Under the President’s FY 2016 proposal, dividends received by a U.S. shareholder from a controlled foreign corporation (“CFC”) would be exempt from tax. However, a 19% minimum tax (with credit given for 85% of the per-country foreign effective tax rate) would make the income generated by CFCs currently taxable. In addition, as part of this transition to what has been called a “quasi-territorial” regime the budget imposes a one-time 14% tax on the accumulated earnings of CFCs. The revenue generated from this one-time tax on accumulated earnings would be earmarked for the Highway Trust Fund and it is believed that it would generate approximately $238.1 billion based on the estimated $2 trillion U.S. companies are currently holding offshore.

Changes to Subpart F Income and the CFC Attribution Rules

The proposed 19% minimum tax would not impact the tax rate applied to subpart F income, which would continue to be taxed currently at domestic U.S. corporate tax rates. However, the budget would modify some of the categories of Subpart F income. First, it would expand the definition of subpart F income to cover digital income and income earned by a CFC from the sale of property manufactured on behalf of the CFC by a related person. Second, the proposal would limit the application of exceptions to Subpart F for certain transactions that use reverse hybrid entities. Third, the proposed budget would also permanently extend the Subpart F active financing exception and look-through rules. Finally, the budget would amend the CFC attribution rules such that stock of a foreign corporation owned by a foreign person is attributed to a related United States person.

Limitation on Deducting Interest Expense

The budget would also seek to limit the interest expenses that are deductible against U.S. income for U.S. members of multinational groups. Under the proposal, the U.S. member’s deductible interest would be limited to its proportional share of the net interest expenses reported on the group’s consolidated financial statement.

Limiting Shifting of Income through Transfers of Intangible Property

The proposal would expand the definition of intangible property under section 936 (and for purposes of sections 367 and 482) to include workforce in place, goodwill, and going concern value, and any other item owned or controlled by a taxpayer that is not a tangible or financial asset and that has substantial value independent of the services of any individual. The proposal also would clarify that where multiple intangible properties are transferred, or where intangible property is transferred with other property or services, the IRS may value the properties or services on an aggregate basis where that achieves a more reliable result.

Anti-Inversion Provisions in the Budget

The budget also makes significant changes to the anti-inversion rules by broadening the definition of an inversion in order to limit the ability of domestic entities to expatriate. Under the proposal, a corporation could be subject to the anti-inversion rules of the Code at a lower ownership threshold resulting in the imposition of additional tax burdens. In particular, the proposed changes include replacing the current 80% ownership test with a greater than 50% ownership test for imposing domestic taxes on the inverted corporation, and eliminating the 60% test. The proposal would also add a special rule whereby, regardless of the level of shareholder continuity, an inversion transaction would occur if (i) immediately prior to the acquisition, the fair market value of the stock of the domestic entity is greater than the fair market value of the stock of the foreign acquiring corporation, (ii) the EAG is primarily managed and controlled in the United States, and (iii) the EAG does not conduct substantial business activities in the country in which the foreign acquiring corporation is created or organized. Finally, the proposal expands the scope of the anti-inversion provisions to cover the acquisition of substantially all the assets of a domestic entity.

Reduction in Corporate Tax Rate

In addition to changes to U.S. international taxation, the budget also contains a number of important provisions that would apply to domestic corporations and businesses. The most significant change is the reduction in the corporate tax rate from 35% to 28%. However, this reduction would be offset by a number of changes to the Code, some of which are described below, that would curtail certain taxpayer friendly provisions.

Tax Incentives for Locating Jobs in the United States

The proposal would create a new general business credit against income tax equal to 20% of the expenses incurred in connection with insourcing a U.S. trade or business. The credit would apply to the reduction or elimination of a trade or business currently conducted outside the United States to the extent it resulted in an increase in U.S. jobs by creating a new or similar business within the U.S. Conversely, the proposal also would disallow deductions attributable to the outsourcing of a U.S. trade or business to the extent it resulted in a loss of U.S. jobs.

Make the Research Credit Permanent and Expand Renewable Energy Credits

The budget also calls for making the research credit permanent for expenditures paid or incurred after December 31, 2014, as well as modifying the current method for calculating the credit and replacing it with a simplified version. The rate would be raised from 14% to 18% for expenditures paid or incurred after December 31, 2015. The proposal would also eliminate the special rate for startups and allow for the application of the credit against the alternative minimum tax (AMT).

The proposal also expands the existing federal income tax incentives available for the production of electricity using wind energy, biomass, geothermal, hydropower and other facilities where construction commences before the end of 2015. For facilities on which construction begins after December 31, 2015 this expansion includes permanently extending the credit and making it refundable as well as eliminating the requirement that the electricity generated be sold to third parties.

Require Mark-to-Market of Financial Derivatives

The FY 2016 proposal would require that derivative contracts be marked to market annually with gain or loss recognized and treated as ordinary income. The proposal defines a “derivative contract” broadly to include any contract the value of which is determined, in whole or part, by the value of actively traded property. Accordingly, contingent debt and notes linked to actively traded property would be taxed as derivative contracts under the proposal.

Repeal LIFO and LCM Methods of Accounting

The proposal seeks to eliminate several tax deferral provisions. One significant example is the repeal of the Last-In, First-Out (“LIFO”) method of accounting which allows taxpayers to determine inventory values by treating the most recently acquired goods as having been sold during the year. Under the proposal, taxpayers who currently use LIFO accounting would be required to change their method of accounting to recover the gain they had deferred ratably over a 10 year period. Similarly, the proposal also calls for the repeal of the lower-of-cost-or-market (“LCM”) method which allows taxpayers to write down the value of inventories to replacement cost. Compliance with this provision would require taxpayers to change their method of accounting and report any resulting gain over a four year period.

Limitation to Deferral of Gain on Like-Kind Exchanges

The proposal also calls for limiting the amount of capital gain that can be deferred on real property like-kind exchanges to $1 million per year (indexed for inflation) per taxpayer. Treasury would be granted the authority to implement aggregation and related party rules. This proposed change would dramatically alter the ability of real estate investors and operators to use like-kind exchanges to defer taxable gain on the exchange of property. Art and collectibles would be excluded from the like-kind exchange provisions.

Changes to Partnership Taxation

The proposal would also extend the partnership basis limitation rules to nondeductible expenditures of the partnership such as charitable contributions and foreign taxes. Under current law, a partner’s distributive share of partnership losses are limited by the partner’s adjusted basis in the partnership at the end of the tax year. The proposal is intended to address prior interpretations of the basis limitation rules which allowed for the deduction of charitable contributions in excess of a partner’s basis. Additionally, the proposal seeks to expand the definition of a “substantial built-in loss” to include the transfer of an interest in a partnership if the transferring partner would have an allocated net loss in excess of $250,000. In contrast, under current law the substantial built-in loss rules apply only if the partnership has a substantial built-in loss in its assets, as opposed to the individual partner.

Financial Fee on Banks and Financial Entities

The proposal imposes a fee on large U.S. and foreign banks and non-bank financial institutions (including insurance companies, savings and loan holding companies, asset managers, and broker-dealers) that is broadly consistent with the principles agreed to by the G-20. The fee would apply to banks and non-bank financial institutions with worldwide assets of more than $50 billion and be assessed on the value of the institution’s liabilities at a rate of seven basis points (.07%). The administration estimates that the fee would raise approximately $112 billion over 10 years and apply to roughly 100 financial firms.

Require Use of Average Cost Method for Calculating Basis

The proposal would require taxpayers to use the average cost basis method for calculating the gain from the sale of stock with a long-term holding period for securities purchased after December 31, 2015. The average cost basis method would be applied to all identical shares of portfolio stock with a long-term holding period held by the taxpayer, including stock held with a different broker or in a separate account, except for portfolio stock held in a retirement or nontaxable account.

Conclusion

The administration’s FY 2016 budget calls for dramatic changes to the U.S. international tax regime, the lowering of corporate tax rates, the elimination of numerous taxpayer friendly provisions, and modifications to individual income and transfer tax provisions. Although many believe that the enactment of many of the tax provisions contained in the budget are unlikely, they may serve as a starting point for future tax reform.

 

 



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