Bipartisan tax package announced, signaling potential changes
How did we get here?
Numerous federal tax changes have been enacted since 2017, ushering in an era of shifting tax rules. Some of those were aimed at achieving policy goals, such as business tax cuts and promotion of green energy production, while others responded to economic conditions like the COVID-19 pandemic. In either case, the legislative process used for many of those bills required the inclusion of phase-outs and expiration dates. The end result is a landscape of tax rules that vary significantly by year.
Additionally, a wide variety of tax proposals have been proposed over the past several years to address identified challenges with existing rules. For example, a few key aspects of the Tax Cuts and Jobs Act (TCJA), enacted in December 2017, included deferred effective dates that pushed taxpayer-unfavorable changes into future years. Chief among those were the required capitalization of research and experimentation (R&E) expenditures under Section 174, tightening of the business interest expense limitation under Section 163(j), and a phase-out of 100% bonus depreciation, each of which are included in this bipartisan tax package. Momentum has been building for legislative changes since at least 2021, as taxpayers began to feel their effects. Therefore, this bipartisan tax package announcement is the culmination of a multiyear process to change specific tax rules.
What is the path to enactment of this bipartisan tax package?
Due to the parties involved and the bipartisan support for such a package in Congress, this current proposal is significant. The House Ways and Means Committee and Senate Finance Committee are responsible for all tax legislation. Thus, an announcement of a proposed tax package by the Chairmen of those committees, representing both political parties, increases the likelihood that legislation will advance. However, there are other important bills currently on the congressional agenda, including funding for the federal government, foreign aid, and border security proposals, among others. Accordingly, the current proposal should be taken seriously, but passage is by no means assured.
If this proposal does advance, it would most likely be completed within the next few weeks. The House Ways and Means Committee conducted a markup of this legislation on January 19 and voted to advance the bill by a vote of 40-3. This now heads to the floor for consideration. Proponents have expressed an intention to complete this before the individual tax filing season officially opens on January 29. Completing a bill on that timeline would minimize disruption to the 2023 tax filing season for both individuals and businesses while allowing individuals to receive timely benefits of an expanded child tax credit with their 2023 tax returns. It’s not yet clear whether that timeline is feasible, but the congressional calendar will likely become more challenging after January.
What is included in the bipartisan tax package?
Deductibility of research and experimentation (R&E) expenses under Section 174
Beginning in 2022, R&E expenses are required to be capitalized and amortized over five years for amounts related to research conducted in the United States and 15 years for research conducted outside of the United States. Prior to 2022, R&E expenses were immediately deductible. The proposal would restore the ability of taxpayers to immediately deduct domestic R&E expenditures through 2025. The treatment of foreign R&E expenses would remain unchanged, so they would continue to be capitalized and amortized over 15 years. The proposal also contains a number of coordinating amendments to fix the manner in which R&E expense capitalization interacts with other areas of tax law such as the requirement to not deduct expenses equal to a research credit and the alternative minimum tax treatment.
The capitalization of R&E expenses has raised complex technical questions while limiting annual deductions. The proposal provides key relief; however, the retention of capitalization of foreign R&E means that many taxpayers will still need to complete annual R&E studies. The IRS and Treasury are already deep in the process of developing guidance on R&E expense capitalization so it’s possible that these changes could significantly delay that process. Deferring technical guidance may cause taxpayers with foreign R&E expenses to continue to grapple with these complex technical questions for quite a bit longer.
Most taxpayers have already filed their 2022 tax returns and capitalized R&E expenses. The proposal permits taxpayers to deduct their capitalized domestic R&E expenses by either amending their 2022 tax returns or making an accounting method change with their 2023 tax returns. Taxpayers opting for the accounting method change route would be permitted to elect to take the entire deduction in 2023 or spread it evenly between 2023 and 2024.
Many taxpayers will likely be faced with important procedural questions depending on the significance of the amount of domestic R&E expenses that were capitalized. Net operating losses can no longer be carried back, and taxable income may drive many other calculations, including the Section 163(j) limitation and foreign tax credits. Whether there is a larger tax benefit by deducting these amounts in 2022, 2023, or across 2023 and 2024 may not always be clear without detailed modeling. Any benefits of deducting these amounts in 2022 may also need to be balanced against the administrative costs of amending tax returns. This is particularly true for partnerships that may not be able to amend their tax returns but would be required to file administrative adjustment requests (AARs). It’s possible that a tax benefit reported on an AAR could result in no tax refund to a partner depending on that partner’s personal tax situation for the year in which the AAR is filed.
Deductibility of business interest expenses under Section 163(j)
The Section 163(j) limitation applies an annual cap on the ability of businesses to deduct interest expense. The limitation is generally 30% of adjusted taxable income (ATI), calculated as taxable income before net interest expense and with several other additions and subtractions. For tax years beginning before 2022, the computation of ATI included an addback for depreciation, amortization, and depletion deductions. However, beginning in 2022, such deductions were no longer added back, which reduced the overall amount of interest expense deductions available to many businesses.
The proposal would restore the depreciation, amortization, and depletion addback in 2024 and 2025. Further, taxpayers would be permitted to elect to apply such addbacks to 2022 and 2023. The current legislative text indicates that such election would apply to both 2022 and 2023.
The change to the ATI computation would be welcome news to many businesses. Since 2022, the ATI computation change has meaningfully restricted interest expense deductions. That tighter computation was also applied during a period in which interest rates were increasing and 100% bonus depreciation was widely applied. Taken together, those factors have resulted in a Section 163(j) limitation that significantly increased tax payments for many businesses.
The inclusion of an elective regime for 2022 and 2023 would provide helpful flexibility for taxpayers. Interest expense deductions that are limited in one year carry forward to the next year. In some cases, the expanded ATI computation in 2024 and 2025 may be sufficient to allow for the deduction of both current and carryforward interest expense. In such case, choosing not to apply the elective retroactivity would eliminate the need to file amended tax returns or AARs. However, other taxpayers who don’t expect to be able to absorb carryforwards in the near future may be more inclined to amend previous tax returns or file AARs. Of note, that decision will be complicated by the fact that a business that elects to apply the more favorable rule in its 2023 tax return would appear to be committing to amend its 2022 tax return as well, so there may not be a middle ground. As noted above with respect to R&E expenses, partnerships that would be required to file AARs may have a much harder choice to ensure that partners do not end up losing tax benefits all together.
Restoration of 100% bonus depreciation
The TCJA expanded and extended bonus depreciation, providing 100% expensing for property placed in service through 2022. Bonus depreciation was then subject to an annual 20% decrease in expensing for property placed in service during each calendar year after 2022 (e.g., 80% in 2023; 60% in 2024; 40% in 2025; 20% in 2026; and 0% in 2027 and later years).
The proposal extends 100% expensing for property placed in service through 2025. It would retain existing law for 2026 and later years, so 20% expensing would apply to property placed in service in 2026, and no bonus depreciation would exist in subsequent years.
The most immediate impact of this change is permitting 100% bonus depreciation in 2023 rather than the previously scheduled 80%. Since most 2023 tax returns have not yet been filed, this change would be implemented on original 2023 tax returns for most taxpayers.
Employee retention credit (ERC) enforcement
Since enactment in March 2020, the employee retention credit (ERC) has been the subject of continual amendments and developments. Initially, those included technical changes to the rules and modification of the effective dates. More recently, developments in the marketplace have triggered a series of escalating enforcement measures by the IRS. Those began with warnings about improper claims, advanced to a temporary pause on new claim processing, and more recently involved the deployment of claim withdrawal and voluntary disclosure programs. The proposal would go further by modifying the program while focusing enforcement efforts on promoters of ERC refund claims. The proposed changes are also expected to largely cover the cost of the rest of the proposal.
Most importantly, the deadline to file refund claims for the ERC would be Jan. 31, 2024. Under current law, most taxpayers have until April 15, 2024, for 2020 ERC refund claims and April 15, 2025, for 2021 ERC refund claims. The proposal would also extend the statute of limitations for the IRS to assess tax to six years for ERCs. Under existing law, a three-year statute of limitations applies to most ERCs, while a five-year statute of limitations applies to ERC for the third and fourth quarters of 2021. The proposal would apply a uniform six-year statute of limitations to all ERC claims. Such statute will run based on the latest of three triggering events: (1) the filing date of the original return for the applicable calendar quarter, (2) the date on which the return is treated as filed under current statute of limitations rules, and (3) the date on which the credit or refund claim is made. The proposal would also coordinate the income tax statute of limitations of the ERC wage deduction disallowance so that taxpayers wouldn’t be adversely impacted by an ERC refund claim deemed invalid after the standard statute of limitations on income taxes had expired.
The proposal has the most immediate impact on taxpayers who have been debating whether to file an ERC refund claim by providing a very limited window in which to make a final decision. While these provisions make clear that Congress is concerned about abusive ERC refund claims, the proposal generally doesn’t directly impact ERC refund claims that have already been filed. However, the extended statute of limitations may cause more taxpayers who have already received their refunds to be examined years into the future.
All other ERC provisions in the proposal are focused on promoters and advisors with respect to ERC claims. These provisions include substantially increasing penalties for those aiding and abetting a taxpayer’s understatement of tax, requiring paid preparers to perform certain diligence requirements when advising on ERC refund claims, and requiring ERC promoters to follow reportable transaction list maintenance requirements. These provisions have varying effective dates.
Other items in the bipartisan tax package
The proposal would also provide for several additional tax changes to both businesses and individuals:
- Expansion of the child tax credit — The proposal would expand the refundability of the child tax credit and also index the $2,000 credit to inflation for 2024 and 2025.
- Disaster relief — Congress has historically enacted periodic legislation that eliminates the 10% of adjusted gross income floor for deducting certain casualty losses, eliminates the $500 floor on each casualty loss, and permits casualty losses to be deducted even when a taxpayer doesn’t itemize. The proposal would extend these provisions for most Presidentially declared disasters occurring from Dec. 28, 2019, through the date of enactment. The proposal would also exclude from income certain wildfire relief payments received by individuals beginning in 2020 through 2025 as well as payments received as compensation for the East Palestine train derailment that occurred on Feb. 3, 2023.
- Form 1099 filing thresholds — Businesses are generally required to issue a Form 1099-MISC or 1099-NEC when payments to certain recipients exceed $600. The proposal would increase this threshold to $1,000 for 2024 and index it to inflation thereafter.
- Expansion of Section 179 expensing — The proposal would slightly increase Section 179 expensing in 2024 from $1.22 to $1.29 million and would increase the phase-out limit from $3.05 million of eligible property placed in service to $3.22 million. While 100% bonus depreciation negates the benefit of this for many taxpayers, this increase may be more beneficial in 2026 and later years.
- Taiwan double-tax relief — While the United States is unable to enter into a bilateral tax treaty with Taiwan due to Taiwan’s unique status, the proposal would provide benefits to Taiwan residents similar to those provided by U.S. tax treaties covering matters such as reductions of withholding taxes, application of permanent establishment rules, treatment of income from employment, and determination of residency. The proposal also provides authorization to the president to enter into a U.S.-Taiwan tax agreement that includes provisions generally conforming with those customarily contained in U.S. tax treaties.
- Affordable housing expansion — The proposal increases the low-income housing tax credit ceiling from 9 to 12.5%, starting 2023 through 2025 and lowers the bond financing threshold to 30% for projects financed by bonds issued before 2026. These provisions have varying effective dates.
The proposal still has a number of hurdles to cross before it can become law. The next several weeks will be a critical period for it to progress through Congress. While this is still far from enacted law, businesses may want to pay particular attention to the details, especially the proposed sunsetting of the ERC on Jan. 31, 2024, to determine if short-term actions may be advisable.