Frustrated after nearly a year of legislative impotence and threatened with the imminent loss of campaign contributions if promised tax cuts were not delivered by the end of 2017, the final two months of 2017 saw Congress’ slender Republican majority hastily cobble together and then enact a ‘tax reform’ package.
Such was the extent of the manoeuvring required that they weren’t even able to give the legislation the title they wanted. Although professionals have generally gone along with referring to the legislation as the ‘Tax Cuts and Jobs Act 2017’ or TCJA for short, this title was struck by the Senate Parliamentarian as being contrary to the procedure under which the legislation was adopted, and so those required to be accurate will be forever stuck with calling the legislation by its correct name, ‘An Act’ to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018’ (‘An Act’).
It’s now been five months since ‘An Act’ was adopted (on December 22, 2017) and pretty much every dire prediction made by professionals about its impact can be seen to be coming true. In an effort to focus on the forest rather than the trees, this article looks at the actual and potential impact of ‘An Act’ on (A) Congress, (B) the IRS, (C) the Courts, (D) the States and (E) taxpayers.
A. Congress — Don’t Hold Your Breath
Prior to ‘An Act’, Congress had consistently followed a disciplined approach to the enactment of tax legislation. Permanent professional staff of the Joint Committee on Taxation of the House and Senate ensured that whatever Congress’ intent, provisions designed to achieve that intent were carefully considered both to eliminate unintended consequences and to ensure clear and comprehensive drafting. Irrespective of whether provisions enjoyed bipartisan support, deliberations occurred in full committee so the input of representatives of both parties could be received.
Even in well-crafted tax legislation, it was inevitable that issues would arise requiring ‘technical correction’ to ensure that the legislation as enacted clearly reflected and implemented Congress’ intent. Such technical corrections legislation typically would be made retrospective to the effective date of the original tax legislation.
There could hardly be a stronger contrast between the previous care Congress has given to ensure the tax law was coherent and comprehensive, and the lack of discipline exhibited in the formulation of ‘An Act’. Constructed over a two-month period and with extensive horse-trading at every stage, ‘An Act’ is, simply put, amateurish (despite the polish provided by the professional draftsmen of the Joint Committee staff). There simply wasn’t time for normal committee deliberation, and Congressional Democrats rightly complained that they were being excluded from the legislative process. The need for comprehensive future fixes (far beyond the limits of what is normally considered ‘technical correction’) was clearly appreciated even as ‘An Act’ was being adopted. However, the partisan nature of the legislative process seems likely to be a major obstacle to any future repair.
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The first opportunity to test the willingness of Congress to address technical corrections was the ‘Consolidated Appropriations Act 2018’, a funding bill that had to be passed before midnight on March 23, 2018 to avoid temporary shut-downs of government agencies due to a lapse in funding. Support of Senate Democrats was essential, or passage could have been delayed through a ‘filibuster’. A single technical correction was proposed to eliminate the ‘grain glitch’, a provision of ‘An Act’ that inadvertently incentivized farmers to sell their output to agricultural cooperatives rather than to corporations. While it was clear the distinction in treatment was inappropriate, unintended and not in the national interest, Congressional Democrats were not minded to cooperate to correct legislation when they had been frozen out of the original legislative process, and therefore demanded a significant and costly concession (a four-year expansion of the low-income housing credit) as the price for their collaboration.
The President expressed dissatisfaction with the Appropriations Act despite signing the legislation. On April 16, 2018, he promised that in the event a future Democratic majority in Congress sought to raise taxes, ‘I’ll veto it.’
The Chief of Staff of the Joint Committee on Taxation advised in an April 25, 2018 speech that the Committee hopes to develop a technical corrections package but could promise no ‘hard deadlines’. He observed that technical corrections legislation ‘typically does not get passed rapidly’, noting that the technical corrections to the Tax Reform Act of 1986 were not passed until two years later in October 1988. Among the things he didn’t note were:
- The Tax Reform Act of 1986 (‘TRA 1986’) was well-crafted.
- The technical corrections to TRA 1986 were enacted in the House by a vote of 356 – 1 and by a voice vote in the Senate (i.e. it was considered unnecessary to count).
- The fact of the matter is that history is no guide to whether or to what extent Congress will be able to fix ‘An Act’ because there has never before been tax legislation like it. Early indications are not promising.
B. The IRS — Don’t Quote Us but ‘An Act’ is not a Model of Sophistication
The agency of the U.S. executive branch which administers the tax law is the Treasury Department, principally through the Internal Revenue Service.
Historically there has been a great deal of cooperation between Treasury/IRS and the private sector including a free flow of information, often delivered/exchanged at tax conferences. In a previous article we reported a statement at a tax conference from one Treasury Department official questioning whether ‘An Act’ was a ‘model of sophistication’. That individual is no longer a Treasury Department official (although happily he was welcomed back at his old law firm) because his candour made his position at the Treasury Department untenable.
Now there is a clear indication Treasury/IRS are closing ranks over ‘An Act’. At a tax conference on May 1 a senior IRS lawyer is reported to have announced that IRS and Treasury Department employees will not comment publicly about the reasoning behind regulations implementing the tax law. “Tax reform issues are extremely sensitive. We’re under direction to keep things low …”
In the meantime, Treasury and IRS guidance on the new law has been extremely limited. Apart from a burst of activity to help shareholders of foreign companies comply with an April 15 deadline to pay their first instalment of ‘transition tax’ (with the last guidance having been delivered on April 13) the general mantra is that comprehensive guidance on at least the international aspects of ‘An Act’ will be released by the end of 2018. There are three problems with this:
- These provisions are all in force now and there are major ambiguities and uncertainties which are preventing taxpayers from knowing how to conduct their affairs.
- There is no indication the IRS has the manpower to deliver even on the promise to provide guidance by year-end.
- The IRS’ authority to fill gaps, much less correct errors, in the legislation is limited and given the significant risk of no comprehensive technical corrections legislation it may not be possible for the IRS to provide all needed guidance.
It seems there is a real risk that some aspects of ‘An Act’ will not be administrable.
C. The Courts — Will the Buck Stop Here?
One advantage of functioning in a system where tax laws are well-drafted is that the courts are able to operate in the manner contemplated by the U.S. Constitution, i.e. to apply and interpret the law in a fair and rational manner. With clear rules come clear guidelines both for courts and professionals.
A case in point is the controversy over the taxation of gains from the disposal by non-residents of interests in U.S. trading partnerships. It was clear that where such a partnership disposed of its assets, its foreign partners would be liable to U.S. tax on their share of the gain. On the other hand, U.S. law generally relieved foreigners of gain from the disposal of property not directly used in a U.S. business, and this seemed to include an interest in a U.S. trading partnership. The IRS concluded the disparity in treatment was inappropriate and in a 1991 published ruling set out its analysis of why gain from the disposal by a non-resident of a partnership interest should be subject to tax. The tax profession was unconvinced, and it took another 26 years before the IRS chose to litigate its ruling position in the case of Grecian Magnesite Mining, 149 T.C. No. 3 (2017), where the Tax Court sided with the taxpayer. As it happens, ‘An Act’ contains a provision to close this perceived loophole. However, in the interim, taxpayers could rely on the advice of their professionals without fear that the courts would overstep their bounds and, instead of applying the law as written, be tempted to apply the law as it should have been written.
One wonders whether the same discipline will be possible when issues under ‘An Act’ come before the courts, in the event no comprehensive technical corrections legislation is enacted. Will the courts adhere to their historic role of applying the legislation, warts and all, or will the unprecedented inadequacy of ‘An Act’ force the courts to expand their role? And while the courts face this kind of pressure, must tax advisers change the way they advise?
An issue we’ve highlighted before is the fact that under ‘An Act’, the new three-year holding period to qualify for long-term capital gains treatment of ‘carried interest’ gains doesn’t apply if the interest is held through a ‘corporation’. This makes sense if the corporation is a ‘C’ corporation subject to corporation tax, since there is no preferential long-term capital gains rate for corporations. However, it makes no sense if the corporation is a tax-transparent ‘S’ corporation, the gains of which will be attributed to individual members who do pay lower tax on long-term gains. In one of its rare early pronouncements on ‘An Act’ the IRS promised regulations which will confirm that the term ‘corporation’ as used in the new legislation on carried interests means only ‘C’ corporations, but this is contrary to statute and therefore seemingly beyond the IRS’ regulatory authority. If Congress can’t enact technical corrections, will the courts adhere to established precedent and declare invalid the promised IRS regulations?
D. The States — We Want a Divorce
The fact that Americans may be subject to income tax at both the State and federal levels places Americans at a disadvantage compared with residents of most other nations. One significant factor that has helped mitigate the cost and inconvenience of facing two levels of income taxation is the fact that the States imposing income tax have generally adopted Federal taxable income as their tax base. Also, fundamental fairness has heretofore dictated that State income tax should be deductible in the determination of Federal taxable income to eliminate economic double taxation, but ‘An Act’ controversially eliminated this deduction.
One outcome of ‘An Act’ which is already clear is the large-scale decoupling of the States’ tax bases from the federal tax base. Idaho, for example, has pegged its tax base to that provided under the Internal Revenue Code as of December 21, 2017, i.e. the day before ‘An Act’ became law, so tax return preparers in Idaho will have to continue to gather information to prepare State returns that has become irrelevant to the Federal computation. Other States are incorporating the new rules, but subject to specific carve-outs that vary widely from State to State. It is clear that compliance with Federal and State income tax rules going forward will require considerably more time on the part of taxpayers and their return preparers.
We’ve reported before about the Constitutional challenge to the denial of the deduction for State income tax which some of the leading high-income tax States have announced will be brought in Federal court. New York has already enacted legislation intended to counteract the Federal change, specifically (a) establishment of a New York charitable organization to which Federal tax-deductible contributions can be made, with the State allowing a dollar-for-dollar offset against the donor’s State income tax liability, and (b) creation of a voluntary employer-level tax with a dollar-for-dollar offset against the relevant employee’s State income tax liability. Other States are actively considering their own fixes. An already overburdened IRS will presumably have to respond to this by issuing rulings confirming the Federal tax consequences of these arrangements, and if the conclusion is reached that the desired Federal consequences are not achieved there is no guarantee taxpayers in the relevant States will accept the IRS’ position.
E. Taxpayers — The Business of America is Tax Restructuring
The new incentives and disincentives, intentional and unintentional, written into ‘An Act’ will of necessity result in significant changes in business models over a broad spectrum of taxpayers. Time and effort are being diverted from carrying on business in order to decide upon and implement these changes. The following illustrates how pervasive the incentives for restructuring may be.
- Whereas the former rules created an incentive for income from intangible assets such as information technology to be earned in foreign subsidiary structures, the new rules are intended to make it tax-neutral whether such income is earned domestically (and eligible for the reduced rate of tax on ‘foreign derived intangible income’ (FDII) or through foreign affiliates (and attributed back to the domestic parent under the controlled foreign corporation (CFC) rules as ‘global intangible low-taxed income’ (GILTI). What doesn’t seem to have been appreciated is that the new rules create a strong incentive for income from tangible assets (such as real estate and equipment) to be shifted from domestic entities (where it is eligible for no special reduced rate of tax) to foreign affiliates (where it will escape U.S. tax under the new territorial regime).
- While modification to the CFC rules was entirely focussed on the effects to U.S. multinational corporations, U.S. individuals and flow-through entities owning significant participations in foreign companies were also affected but without essential guidance about how the rule changes will apply to them. At least while such guidance remains unavailable those wishing to play it safe may introduce new U.S. corporate holding entities for their foreign participations, assuming this can be done without unacceptable foreign tax costs.
- The new limit on the deductibility of interest by large enterprises to 30% of taxable income clearly will require significant changes in the way some companies have financed themselves. This will not merely affect companies trading in the U.S. Rules for attributing income from a CFC to a domestic shareholder assume that the same deductions are available to the CFC as would be allowed to a domestic corporation, so the sudden disallowance of a large portion of corporate interest expense may greatly increase the amount of a U.S. shareholder’s income inclusions without providing the wherewithal to pay the increased tax liability. International restructurings will thus also be the order of the day.
- A strong contender for the coveted title of worst provision of ‘An Act’ is the new 20% deduction for ‘qualified business income’ of an unincorporated business (the ‘pass-through deduction’). Because Congressional Republicans were committed to enacting a bill without the help of the Democrats, they were vulnerable to being held up by members of their own party, a few of whom publicly insisted that they would not vote for the new legislation if there weren’t tax breaks for unincorporated business in tandem with the central provision of a reduction in the corporation tax rate. Massive planning is being implemented to maximize the savings potential of the pass-through deduction.
- See D. above for the machinations arising from ‘An Act’s’ elimination of the deduction for State income tax.
There are up-coming mid-term elections in November. As the current administration’s single significant legislative accomplishment, ‘An Act’ will undoubtedly continue to bathe in the political spotlight and be touted as a great success regardless of its many obvious flaws.