Today, I read through the provisions of the Tax Reform Act of 2014. In case you have been living under a rock, Congress has made it their mission to simplify the Tax Code. This week the House Ways and Means committee released their preliminary report. The following is a summary, and my thoughts on this reform. Now, before I give my thoughts, I want to point something out: I am not biased in any way, nor do I have a political opinion. The point of giving my thoughts, is purely from a tax professional’s perspective.
Before we begin, let’s talk about the Tax Reform Act of 1986. This was the first time that the Internal Revenue Code, had a major overhaul. It brought us things such as passive income, passive loss, capital gains tax, and other things. I have been in practice since 1994, so I don’t know a time before the tax Reform Act of 1986. I can only give my perspective, from that point in time.
The first part of this reform would create three different tax brackets, instead of seven that we work with now. The 10% rate would apply to single filers with taxable income below $37,400 and joint filers with taxable income below $74,800. This would be taxpayers and are currently in the 10% or 15% tax bracket today. The 25% rate would apply to taxable income above these amounts. The 25% tax bracket is where most Americans would fall. The 35% rate would begin at the same income levels as the current 39.6% bracket, which is above $400,000 for single filers and $450,000 for joint filers. Something interesting happened with the 35% tax bracket. Income derived from qualified domestic manufacturing income (QDMI) would not apply. The question is, what is QDMI?
QDMI generally would be net income attributable to domestic manufacturing gross receipts, which would include gross receipts derived from
- any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the U.S., or
- Construction of real property in the U.S. as part of the active conduct of a construction trade or business. Income that either is net earnings from self-employment or results from an adjustment under IRC § 481, which are changes that result from a change in accounting method. These would not qualify as QDMI. Puerto Rico would be considered "domestic" for these purposes.
Currently IRC § 199 dictates qualified production activities. This would be similar to QDMI. IRC § 199 is basically about domestic product manufacturing. IRC § 199 are businesses with "qualified production activities" and can take a tax deduction of 3% from net income. This is a tax break pure and simple. The more complicated the business, the more complicated the math for calculating the Domestic Production Activities Deduction. In a nutshell, businesses engaged in manufacturing and other qualified production activities will need to implement cost accounting mechanisms to make sure their tax deduction is accurately calculated.
A business engaged in the following lines of business may qualify for the Domestic Production Activities Deduction. These are the "qualified production activities" eligible for claiming the deduction under IRC § 199:
- Manufacturing based in the United States,
- Selling, leasing, or licensing items that have been manufactured in the United States,
- Selling, leasing, or licensing motion pictures that have been produced in the United States,
- Construction services in the United States, including building and renovation of residential and commercial properties,
- Engineering and architectural services relating to a US-based construction project,
- Software development in the United States, including the development of video games.
In regards to the Tax Reform Act of 2014 QDMI appears to be the same.
The Tax Reform Act of 2014 would tax long-term capital gains and qualified dividends at the same rate as applies to ordinary income, but with 40% of gains and dividends excluded. This is big. What that means is that 40% of capital gains and dividends are excluded from income. Currently, 100% are includable in income. The 40% exclusion basically means that gains and dividends that would otherwise be taxed at 10% would effectively be taxed at 6%, and gains and dividends that would otherwise be taxed at 25% would effectively be taxed at 15%.
The Tax Reform Act of 2014 would provide an increased standard deduction of $11,000 for individuals and $22,000 for married couples (both indexed for inflation). The additional standard deduction for the elderly and the blind would be eliminated. The Joint Committee on Taxation estimated that the increased amounts would result in nearly 95% of taxpayers not having to itemize. An interesting inclusion is that single filers with at least one qualifying child could claim an additional deduction of $5,500, regardless of whether or not they itemize deductions.
The child credit would be increased to $1,500 and would be allowed for qualifying children under the age of 18, and a reduced credit of $500 would be allowed for non-child dependents (both indexed for inflation). The credit would be refundable to the extent of 25% of the taxpayer's earned income (earned income in excess of $3,000 before 2018). The credit would not begin to phase out until Modified Adjusted Gross Income exceeds $413,750 for single filers and $627,500 for joint filers.
The Tax Reform Act of 2014 would gradually reduce the current $1 million cap on the amount of mortgage interest that can be deducted beginning with new mortgages taken out in 2015 such that the limit for mortgages taken out in 2018 or later would be $500,000. Homeowners would still be able to deduct interest on the first $500,000 of mortgage debt on a pro rata basis (i.e., a taxpayer with a $1 million mortgage could deduct half of his mortgage interest).
The Tax Reform Act of 2014 would reduce the existing 15 tax breaks for higher education into five: the American Opportunity Tax Credit, the deduction for work-related education expenses, the exclusion of scholarships and grants, gift tax exclusion for tuition payments, and tax-free 529 savings plans.
The new AOTC would provide a 100% tax credit for the first $2,000 of certain higher education expenses and a 25% tax credit for the next $2,000 of such expenses. It would be available for up to four years of higher education, and eligible expenses would include tuition, fees and course materials. The first $1,500 of the credit would be refundable, and it would generally phase out for MAGI between $86,000 and $126,000 for joint filers and $43,000 and $63,000 for other filers.
The employee's share of payroll taxes would be offset by a credit against such taxes, while the employer's share would be rebated through a refundable income tax credit. Only taxpayers with at least one qualifying child could qualify for the credit against the employer's share of payroll taxes. For taxpayers without a qualifying child, the maximum credit amount would be $200 for joint filers ($100 for other filers). For taxpayers with one qualifying child, the maximum credit would be $2,400. For taxpayers with more than one qualifying child, the maximum credit would be $4,000 in the case of a joint return and $3,000 in other cases (all credit amounts indexed for inflation).
A special transition rule would apply to tax years 2015, 2016, and 2017 that would make the credit equal to 200% of the taxpayer's payroll taxes (both employee and employer shares). In addition, taxpayers with one qualifying child could claim a maximum credit of $3,000 (rather than $2,400), and taxpayers with two or more qualifying children could claim a maximum credit of $4,000, regardless of filing status.
The credit would phase out as AGI exceeds certain levels. For taxpayers with qualifying children, the credit would begin phasing out at $20,000 for single filers and $27,000 for joint filers. For taxpayers without qualifying children, the credit would begin phasing out at $8,000 for single filers and $13,000 for joint filers (phaseout levels indexed for inflation).
Retirement savings. For future contributions, the Tax Reform Act of 2014 would allow up to $8,750 (half of the contribution limit) to be contributed either to a traditional or Roth account. Any contributions in excess of $8,750 would be dedicated to a Roth-style account, making these savings tax-free during retirement. The income eligibility limits for contributing to Roth IRAs would also be eliminated.
Repealed provisions. The Tax Reform Act of 2014 would also repeal a host of existing provisions, including the following:
- itemized deductions for expenses attributable to the trade or business of performing services as an employee;
- deduction for personal casualty losses;
- deduction for tax preparation expenses;
- itemized deduction for medical expenses;
- deduction for alimony payments (and corresponding inclusion in gross income by payee);
- deduction for moving expenses;
- deduction and exclusions for contributions to medical savings accounts;
- 2% floor on miscellaneous itemized deductions;
- overall limitation on itemized deductions ("Pease" limitation);
- exclusion for employee achievement awards;
- the special rule permitting recharacterization of Roth IRA contributions as traditional IRA contributions; and
- the exception to the 10% penalty (on early distributions from retirement plans and IRAs) for up to $10,000 to pay for first-time homebuyer expenses.
My thoughts are that tax reform needed, however, is this really simplifying the Code? It seems like it may be taking a couple of steps forward, but huge steps back.
For any questions, email Craig W. Smalley, E.A., C.E.P.®, C.T.R.S.® at firstname.lastname@example.org
Craig Smalley is the managing partner of CWSEAPA®, LLP. CWSEAPA®, LLP is a nationally recognized brand of accounting and financial services. CWSEAPA®, LLP is headquartered in Wilmington, DE with offices in Florida and Nevada. You can visit them on their website at www.cwseapa.com
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