The House Committee on Ways and Means has been working on tax reform and held 30 Congressional hearings during the 112th Congress, formed 11 bipartisan Tax Reform Working Groups, conducted a nationwide tax tour, released two options for Small Business Tax Reform and three separate discussion drafts. On February 26, 2014, the House Committee Chairman Rep. Dave Camp [R-MI] released a draft of legislation of the Tax Reform Act of 2014.
ESOPs are Not Directly Impacted by the Draft Legislation
As ESOP Association President J. Michael Keeling noted in his February 28, 2014 Tax Reform Update, the fact that nothing in the 979 pages of draft legislation, or supporting materials, directly impacts employee stock ownership plans (ESOPs) is positive news for the ESOP community:
The closest areas of impact are the repeal of the exclusion of Net Unrealized Appreciation (NUA) in employer securities and cutbacks to 401(k) plans and retirement savings.
Net Unrealized Appreciation (NUA)
Net Unrealized Appreciation (NUA) provides special tax benefits for the distribution of employer stock from a qualified retirement plan if certain requirements are met (including taking an in-kind lump sum distribution within one tax year directly from the plan). Only the original cost basis of the company stock is taxed at ordinary income rates. The NUA is taxed at long-term capital gains rates at the time the company stock is sold (which is usually immediately for privately held ESOPs). Any additional appreciation after the distribution from the qualified plan to the time the company stock is sold is taxed using the long-term or short-term capital gains rates, depending on the holding period. In addition, any applicable 10% early withdrawal penalty is only applied towards the cost basis and not the NUA. The draft legislation eliminates this special tax benefit.
401(k) Plans and Retirement Savings
While the legislation makes no direct mention of ESOPs, the reform directly impacts pensions and retirement plans. Some of the more notable items include 1) making 401(k) deferrals for certain individuals subject to a 10% tax (in addition to full taxation when distributed), 2) freezing the 401(k) and Pension Plan limits until 2023, 3) making 50% of the current deferral limit a Roth limit (after-tax), and 4) eliminating new Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) 401(k) plans going forward. We are left to speculate the impact that the reduction of the pension limits would have on the ESOP limits, as both are defined contribution plans under the Internal Revenue Code. Here is a full listing from the draft legislation:
Subtitle G—Pensions and Retirement
PART 1—INDIVIDUAL RETIREMENT PLANS
Sec. 1601. Elimination of income limits on contributions to Roth IRAs.
Sec. 1602. No new contributions to traditional IRAs.
Sec. 1603. Inflation adjustment for Roth IRA contributions.
Sec. 1604. Repeal of special rule permitting recharacterization of Roth IRA contributions as traditional IRA contributions.
Sec. 1605. Repeal of exception to 10-percent penalty for first home purchases.
PART 2—EMPLOYER-PROVIDED PLANS
Sec. 1611. Termination for new SEPs.
Sec. 1612. Termination for new SIMPLE 401(k)s.
Sec. 1613. Rules related to designated Roth contributions.
Sec. 1614. Modifications of required distribution rules for pension plans.
Sec. 1615. Reduction in minimum age for allowable in-service distributions.
Sec. 1616. Modification of rules governing hardship distributions.
Sec. 1617. Extended rollover period for the rollover of plan loan offset amounts in certain cases.
Sec. 1618. Coordination of contribution limitations for 403(b) plans and governmental 457(b) plans.
Sec. 1619. Application of 10-percent early distribution tax to governmental 457 plans.
Sec. 1620. Inflation adjustments for qualified plan benefit and contribution limitations.
Sec. 1621. Inflation adjustments for qualified plan elective deferral limitations.
Sec. 1622. Inflation adjustments for SIMPLE retirement accounts.
Sec. 1623. Inflation adjustments for catch-up contributions for certain employer plans.
Sec. 1624. Inflation adjustments for governmental and tax-exempt organization plans.
We have been following the progress of tax reform in the September 2013 ESOP and Corporate Tax Reform Update and the March 2013 ESOP and Corporate Tax Reform Update.
Washington, DC - Today, Ways and Means Committee Chairman Dave Camp (R-MI) released draft legislation to fix America’s broken tax code by lowering tax rates while making the code simpler and fairer for families and job creators. Camp’s latest draft, the “Tax Reform Act of 2014,” spurs stronger economic growth, greater job creation and puts more money in the pockets of hardworking taxpayers.
Based on analysis by the independent, non-partisan Joint Committee on Taxation (JCT), without increasing the budget deficit, the Tax Reform Act of 2014:
Creates up to 1.8 million new private sector jobs.
Allows roughly 95 percent of filers to get the lowest possible tax rate by simply claiming the standard deduction (no more need to itemize and track receipts).
Strengthens the economy and increases Gross Domestic Product (GDP) by up to $3.4 trillion(the equivalent of 20 percent of today’s economy).
Based on calculations using data provided by JCT, the average middle-class family of four could have an extra $1,300 per year in its pocket from the combination of lower tax rates in the plan and higher wages due to a stronger economy.
Discussing the need to fix America’s broken tax code, Camp said, “It is no secret that Americans are struggling. Far too many families haven’t seen a pay raise in years. Many have lost hope and stopped looking for a job. And too many kids coming out of college are buried under a mountain of debt and have few prospects for a good-paying career. We’ve already lost a decade, and before we lose a generation, Washington needs to wake up to this reality and start offering concrete solutions and debating real policies that strengthen the economy and help hardworking taxpayers. Tax reform is one way we can do that.”
During Camp’s three years as Chairman of the Ways and Means Committee, both Democrats and Republicans on the Committee have invested significant time and energy to better understand how today’s broken tax code affects families and job creators. Going to great lengths to ensure that the real experts – individuals, families and job creators of all sizes and industries – were a part of the conversation, this transparent, “everyone gets a seat at the table” process involved more than 30 separate Congressional hearings dedicated to tax reform, 11 separate bipartisan tax reform working groups created in conjunction with Ranking Member Sander Levin (D-MI), three discussion drafts looking at discrete areas of the tax code and more than 14,000 public comments at TaxReform.Gov.
“This legislation does not reflect ideas solely advanced by Democrats or ideas solely advanced by Republicans, nor is it limited to the halls of Congress,” said Camp. “Instead, this is a comprehensive plan that reflects input and ideas championed by Congress, the Administration and, most importantly, the American people. In other words, it recognizes that everyone is a part of this effort and can benefit when we have a code that is simpler and fairer. I am hopeful that lawmakers on both sides of the aisle – and partners at both ends of Pennsylvania Avenue – take a close look at this plan and share their thoughts and ideas, and those of their constituents. The bottom line: just saying ‘no’ is not a solution. Washington must make real progress on the critical issues of the day, the most important of which is strengthening the economy. We can, and need, to work together to craft a plan that fixes our broken code and strengthens the economy so there are more jobs and bigger paychecks for hardworking taxpayers.”
Highlights of the Tax Reform Act of 2014 include:
New Individual and Corporate Rate Structure: Flattens the code by reducing rates and collapsing today’s brackets into two brackets of 10 and 25 percent for virtually all taxable income, ensuring that over 99 percent of all taxpayers face maximum rates of 25 percent or less. The plan also reduces the corporate rate to 25 percent.
Larger Standard Deduction: Makes the code simpler and fairer by providing a significantly more generous, inflation-adjusted standard deduction of $11,000 for individuals and $22,000 for married couples.
Larger Child Tax Credit: Increases the child tax credit to $1,500 per child, adjusts it for inflation going forward and expands the number of families that can claim the credit.
Simpler, Improved Taxation of Investment Income: Taxes long-term capital gains and dividends as ordinary income, but exempts 40 percent of such income from tax – resulting in a three percentage point decrease from the maximum rates individuals pay today on such income while also achieving the lowest level of double taxation on investment income in modern history.
No AMT: In addition to lowering tax rates for families and all job creators, the plan repeals the Alternative Minimum Tax (AMT) for individuals, pass-through businesses and corporations.
Easier Education Benefits: Adopts recommendations stemming from the bipartisan working groups to consolidate education tax benefits so, along with the additional money from stronger economic growth, families can more easily afford the costs of a college education.
Modernized International System: Modernizes the international tax code for the first time in more than 50 years while protecting jobs, wages and profits from being shipped overseas.
Permanent R&D Incentive: Invests in innovation by making permanent an improved Research & Development Tax Credit.
More Affordable Healthcare: While the plan generally leaves ObamaCare policies untouched and for a later debate on healthcare, there are two main exceptions given strong bipartisan support for: (1) repeal of the medical device tax and (2) repeal of the medicine cabinet tax, which prohibits use of funds from tax-free accounts to purchase over-the-counter medication without first obtaining a prescription.
IRS Accountability: Cracks down on IRS abuses and reduces massive waste, fraud and abuse. The plan also contains provisions prohibiting implementation of recently proposed rules affecting 501(c)(4) organizations and provides victims with information regarding the status of investigations into violations of their taxpayer rights.
Infrastructure Investment: Dedicates $126.5 billion to the Highway Trust Fund (HTF) to fully fund highway and infrastructure investment through the HTF for eight years.
Simplification for Seniors: Reflecting a proposal supported by AARP and ATR, the plan requires the IRS to develop a simple tax return to be known as Form 1040SR, for individuals over the age of 65 who receive common kinds of retirement income like annuity and Social Security payments, interest, dividends and capital gains.
Charitable Giving: Expands opportunities to make tax-deductible contributions past the end of the tax year, makes permanent conservation easement incentives, simplifies exempt organization taxes and sets a floor instead of a cap to the amount of donations that can be deducted. The economic growth in this plan will increase charitable giving by $2.2 billion annually.
Shrinks and Simplifies the Income Tax Code: In addition to easing complexity and compliance burdens by adopting a larger standard deduction, enhanced child tax credit and lower rates, the plan repeals over 220 sections of the tax code; cutting the size of the income tax code by 25 percent.
In keeping with previously released drafts, the Committee seeks input and feedback on technical and policy issues raised by the draft released today. The Committee also invites input on the accompanying technical explanation prepared by the JCT staff, a document that could serve as the basis for similar legislative history on any future tax reform legislation that may be considered by the Committee. Additionally, as it further examines options arising from the budgetary and economic analysis, the Committee is especially interested in receiving constructive feedback on areas listed below.
1. Extenders Policy ($1 Trillion): The proposal has been scored by JCT as deficit neutral; it does not increase the budget deficit relative to the projected deficits for the FY2014-23 budget window. CBO’s revenue baseline for this period assumes that a number of tax policies expire and are not renewed. However, CBO has noted that “[n]early all of those provisions have been extended previously; some, such as the research and experimentation tax credit, have been extended multiple times.” Including a permanent extension of these policies would result in the revenue baseline being almost $1 trillion lower over the FY2014-23 budget window than projected. In such a scenario, the proposal would therefore reduce the deficit – mostly through revenue increases – potentially by as much as $1 trillion (without considering all potential interactions among those policies and the proposal). CBO annually presents an “alternative fiscal scenario” that assumes these tax provisions are made permanent – the same assumption generally used for spending programs in CBO’s traditional baseline. The Committee is interested in feedback on which (including none or all) of these expiring tax provisions should be included in the revenue baseline for purposes of determining whether the proposal is deficit neutral.
2. Dynamic Revenue ($700 Billion): JCT’s analysis shows that the additional economic growth that would result from the enactment of tax reform would generate up to an additional $700 billion in tax receipts over the FY 2014-2023 budget window as a result of increased employment and higher wages. This additional revenue, however, is not taken into account as part of JCT’s determination that the proposal is deficit neutral. As a result, under the proposal as currently structured, this additional revenue would be available to the Federal government for a variety of purposes. The Committee is interested in feedback on how this additional revenue should be treated (e.g., should it be used to further lower tax rates or to provide other tax benefits, should it be dedicated to deficit reduction, or should it be dedicated to some combination of the two).
3. Household Impact: The proposal has been scored by JCT as being distributionally neutral; it does not significantly change the share of taxes paid by or the average tax rate for each income cohort reported by JCT. However, each income cohort reported by JCT includes a heterogeneous mix of taxpayers. For example, the combination of lower rates, the increase in the size of the standard deduction, and the reforms to the child tax credit and EITC will affect households differently depending on the number of children in the household and whether the taxpayer files jointly. The Committee is interested in feedback as to whether and how these more detailed circumstances should be analyzed and whether there are certain distributional outcomes that are more preferable than others (e.g., effects on households with multiple children versus households without children within the same income cohort).
4. Economic Modeling: JCT’s analysis of the proposal includes an analysis of the macroeconomic effects of tax reform on the U.S. economy, which is sometimes referred to as a dynamic score. This dynamic score shows that the proposal would result in substantial additional economic growth and job creation as compared to the status quo. JCT used two different economic models and a variety of assumptions to calculate the dynamic score. The two models take different approaches to modeling the impact of the proposal on the U.S. economy. For example, one model, the MEG model, cannot fully account for the breadth of the changes to international tax policy made by the proposal and therefore understates the extent of additional investment in the U.S economy, particularly for investment in high-technology, IP-intensive sectors. The OLG model, on the other hand, contains a fiscal constraint that requires the debt to GDP ratio to be held constant between the pre- and post-reform economy, thus failing to capture the full benefits of reduced budget deficits on the economy. The Committee is interested in feedback on the methodology and parameter estimates used by JCT in performing the macroeconomic analysis and recommendations on how this analysis can be improved.
5. Greater Compliance: The current complexity of the tax code makes compliance difficult and facilitates billions of dollars in improper payments and fraud. The most recent estimate shows that the tax gap amounts to $450 billion annually. The proposal includes a number of reforms that would substantially simplify the tax code and improve reporting and compliance. This improved compliance is partially – but not fully – incorporated into JCT’s analysis of the proposal. The Committee is interested in feedback on how to analyze the impact of the proposal on improving compliance, closing the tax gap, and reducing improper payments and fraud. The Committee is interested in receiving analysis that would quantify the extent of the improved compliance and recommendations for how measurements of improved compliance should be factored into any analysis in determining whether the proposal is deficit neutral.