Major Tax Reform Plan Unveiled in Congress: Pay-Go Rules Invoked

Summary:
Rep. Charles Rangel (D-NY) introduced his keenly anticipated and publicly discussed tax reform bill, H.R.3970, on October 25. Rangel, who chairs the tax writing committee of the House of Representatives, describes his bill as “the mother of all tax bills,” causing Washington insiders to routinely refer to it as the “Mother” bill. The good news for NAIFA members is that in its current form it leaves insurance products and programs largely unscathed. But before NAIFA members become too complacent, please remember that this is just the starting point of a very long process.

H.R. 3970 is a trillion-plus dollar package of positive and negative tax law changes that, when added up, neither increases nor loses total tax revenue. It is, in other words, tax neutral. In its neutrality, the bill demonstrates how the “Pay-Go” budget principals Congress adopted last January will work in the current Congress. The bill eschews the base-broadening, simplification approach that characterized many tax reform proposals over the last 12 years. Instead, it focuses on a few very large items—including repeal of the individual alternative minimum tax (AMT) and imposition of new surtaxes on high-income taxpayers to pay for repealing the AMT.

The bill does contain some provisions that will have an impact on insurance practices if it becomes law. Primarily, though, the bill focuses on high-earning taxpayers, corporate tax rates and a special group of taxpayers involved with hedge funds, venture capital and private equity operations who defer compensation in an offshore (tax haven) company. The tax hike in the latter category alone is more than $22 billion.

Estate Tax and Capital Gains/Dividends Tax Rates
Before getting into some details of H.R. 3970, perhaps it is worth noting that among the most significant impacts on insurance interests in the Rangel tax reform plan is what it does not do. It does not provide for extension of 2001 and 2003 tax cuts that are due to expire at the end of 2010. Thus, if H.R.3970 were to be enacted, the 15 percent tax rate on dividends and capital gains would expire, as would repeal of the estate tax (which would revert to the 2001 level of $1 million in unified credit and 55 percent top rate). Many of the other 2001 and 2003 tax cuts have already been made permanent—e.g., the pension provisions (including increases in annual contribution limits) enacted in 2001 in EGTRRA, which were made permanent by the 2006 Pension Protection Act.

One potential impact from this tax reform provision could come from the reaction of taxpayers who would be subject to the new surtaxes, and are perhaps more interested in tax-advantaged vehicles into which to put their investment income.

Following are details about this proposed rewrite of the U.S. Tax code.

Individual Tax Reform, Corporate Tax Reform, Extenders

H.R.3970 is divided into three parts:

• Individual tax reform
• Corporate tax reform
• A package of extensions of current law tax credits and deductions that are due to expire by the end of the year, along with revenue to offset the cost of the extension.

The extenders (and their offsets) are likely to be considered by Congress before the end of the year. The other sections of the "Mother" will more probably wait until 2008 (or later) for Congressional attention. The long-range provisions are described separately, after this summary of the AMT patch/extenders package.

Non Qualified Deferred Compensation: The package of extenders (and their offsets) included in H.R.3970 includes a narrowly crafted set of provisions that would eliminate the ability of those involved in hedge funds, private equity and venture capital to defer compensation when their deferred compensation arrangements include an offshore tax haven corporation. As supported by NAIFA, this proposed rule would not apply to deferrals made by executives working in other industries, or to deferrals that involve companies that pay taxes under U.S. tax law deferred compensation rules or foreign tax systems with similar rules. These narrow nonqualified deferred compensation (NQDC) provisions in H.R.3970 would raise $22.64 billion over 10 years.

Alternative Minimum Tax “Patch:” H.R.3970 extends for one-year current law’s increased exemption amount and relief for nonrefundable personal credits for the AMT. Without this temporary fix, the number of taxpayers hit by the AMT would jump from about 4 million in 2007 into the 25 millions in 2008. The Joint Committee on Taxation (JCT) estimates this so-called AMT patch has a one-year $49.6 billion revenue cost. The patch is designed to keep the number of AMT taxpayers at its current level of four million.

IRA Contributions to Charities, Mental Health Parity, and Other Extenders: The bill also includes provisions to extend for one year current law for a package of 32 special provisions that provide tax advantaged rules for a wide range of activities. These range from an above-the-line deduction for qualified tuition costs for middle and low income taxpayers, to extension of the research and development tax credit, to extension of the deduction for state and local sales taxes, to the tax credit for a first-time home purchase in the District of Columbia. Only two of the 32 have any direct relevance to insurance: extension of the ability of taxpayers to make tax-free contributions (up to $100,000) to charities directly from their IRAs, and extension of the $100/day penalty tax on health insurance plans that fail to comply with mental health parity rules.

AMT Patch/Extender Offsets: The offsets for the AMT patch and the extenders are permanent provisions rather than one-year extensions —unlike the extenders they are paying for. These include, in addition to the narrow NQDC restrictions, three high-dollar provisions. These are:

• Carried Interest: The bill would require investment fund managers to treat carried interest (payments made for managing certain high-risk investments) as ordinary income rather than as capital gain. This provision would raise $25.66 million over 10 years.

• Restoration of “PEP/Pease” Restrictions: In effect from 1986 through 2006, the phase-out of the personal exemption (PEP) and the rule that limits the value of deductions to 15 percent (Pease—named for its Congressional sponsor back in 1986) would be re-imposed on high-income taxpayers. The PEP and Pease restrictions, estimated to raise $28.58 billion over 10 years, would apply to taxpayers with adjusted gross incomes in excess of $250,000 ($500,000 for married couples).

• Surcharge on Two Percent Floor on Miscellaneous Itemized Deductions: The bill would also raise $7.13 billion by adding a surcharge on the 2 percent floor on miscellaneous itemized deductions. Generally, if a taxpayer is subject to the replacement tax surcharge (4 percent and 4.6 percent surcharges that would replace the AMT), their miscellaneous itemized deductions would be limited not only by the current law 2 percent floor, but also by 5 percent of the amount by which their AGI exceeds the replacement tax threshold. In other words, for affected taxpayers miscellaneous itemized expenses would be deductible only to the extent they exceed 2 percent of AGI, and 5 percent of the amount by which AGI exceeds the replacement tax threshold.

This section of H.R.3970 also contains rules that refine the carried interest provisions for corporations formed in tax haven jurisdictions aimed at improving returns for pension plans, universities and other tax-exempt entities that invest in hedge funds. It also modifies related person rules governing tax-sharing agreements, and clarifies that shareholder-employees of service S corporations and partner-employees of service partnerships are liable for all their self employment taxes. Needless to say, these are all very complicated areas of current tax law.

Congressional Action Expected Within Weeks: Democratic Congressional leaders are urging rank-and-file lawmakers as well as committee chairs to be prepared to get this legislation through the tax writing Committee and ready for floor action prior to November 16. Consequently, the House Ways & Means Committee plans to mark up an AMT patch/extenders bill—and all its offsets—within the next two weeks. Observers believe that while some of the offsets may face rough sledding in the Senate, the House is likely to approve the AMT patch/extenders package as proposed.

“Mother” Replaces Individual AMT with High-Income Surtaxes, Cuts Corporate Tax Rates

While H.R.3970 contains a one-year “fix” of the Alternative Tax, it also proposes to replace it permanently with new surtaxes on high amounts of adjusted gross income. It also cuts corporate tax rates, and makes these trillion-plus changes revenue neutral by making broad revenue-raising changes to both individual and corporate tax rules. Few of the changes have direct impact on insurance.

Individual Tax Reform

AMT Repeal/Replacement Income Tax Surtax: Generally, the Rangel tax reform plan repeals the AMT and replaces it with surtax on income earned by well-off taxpayers. A 4 percent surtax would be imposed on income earned by taxpayers with adjusted gross income of $200,000 (married, filing jointly) or more—or, if greater, on income levels determined by Treasury to encompass the top 10 percent of those who currently pay the AMT. A 4.6 percent surtax would be imposed on adjusted gross income in excess of $500,000 for married couples --$250,000 for single taxpayers. AMT repeal is estimated to be a 10-year $795.66 billion revenue loser. The replacement surtaxes would together raise $831.70 billion over 10 years.

Other individual tax reform provisions in H.R.3970 include an indexed increase of $850 (married) or $425 (individual) or $625 (head of household) in the standard deduction. This provision would lose $47.92 billion over 10 years. The bill also enhances the earned income tax credit and the refundable child tax credit (at a 10-year cost of $38.26 billion).

Corporate Tax Reform

Corporate Rate Cuts: H.R.3970 would cut corporate tax rates from current law’s 35 percent to 30.5 percent, at a 10-year cost of $363.84 billion. The bill proposes to offset this cost by, among other things, repealing the Internal Revenue Code section 199 domestic production activities deduction ($114.93 billion over 10 years), requiring U.S. corporations that defer income through controlled foreign corporations to also defer the deductions that are associated with this income ($106.39 billion over 20 years). It would also repeal the last-in first-out (LIFO) accounting method—with an eight-year spread (i.e., income realized by repeal of LIFO could be taken into account over an eight-year period). The revenue raised by repeal of LIFO would amount to $106.51 billion over 10 years.

Small Business Expensing: Another tax corporate reform in H.R.3970 is the permanent extension of the small business expensing rules. At a cost over 10 years of $20.55 billion, the rules would allow small businesses to expense $125,000 (indexed) with a phase-out threshold of $500,000 (also indexed).

Economic Substance Doctrine Codification: Also included in H.R.3970 is a $3.59 billion clarification of the economic substance doctrine. Intended to not change current judicial standards, the codification of the economic substance doctrine would require that to avoid being characterized as a tax shelter, a transaction would have to change, in a meaningful way other than the taxpayer’s tax position, the taxpayer’s economic position, and that there be a substantial non-tax purpose for entering into the transaction. This provision would also impose a 20 percent penalty on understatements of tax liability attributable to a transaction lacking economic substance. The penalty would rise to 40 percent when the relevant facts (affecting the tax treatment of the transaction) are not adequately disclosed.

Corporate Tax Offsets: Other offsets in the “Mother” bill’s corporate tax reform package include a modification of the dividends received rules. Generally, the dividends received deduction would be lowered from 80 to 70 percent and from 70 percent to 60 percent for a 10-year revenue gain of $4.6 billion. The bill would also repeal the current law rules that allow U.S. corporations to elect special interest allocation rules that reduce the amount of interest expense allocated to foreign assets ($26.2 billion over 10 years); a $6.4 billion provision that changes the rules regarding tax haven country corporations routing income for which there is a deductible payment to a country with which the U.S. has a tax treaty; a rule that requires corporations to value inventories at cost ($7.15 billion), and a $20.7 billion provision that would increase the current 15-year amortization period for section 197 intangibles to 20 years.

More Corporate Tax Offsets: H.R.3970 would raise $606 million over 10 years by requiring recognition of ordinary income on the exercise of a stock option in an S corporation with an ESOP, and another $881 million by terminating the domestic international sales corporation provisions. Finally, the bill includes a $235 million offset from clarifying the gain recognized in certain spin-off transactions.

Conclusions: If you’ve gotten this far in reading the details of the “Mother” bill, you’ve discovered why a lot of people who do not necessarily agree with the thrust of H.R.3970have come up with more colorful descriptions of the bill that involve variations on the “Mother” theme. This bill is very long and very complicated. With an election year coming up, it will no doubt sharpen the substantive tax debate in Congress.

Back to November 1, 2007, NAIFA Frontline