News & Insights

Budget Reconciliation Act Proposal

To address the expiration of certain Tax Cuts and Jobs Act of 2017 (TCJA) provisions, the House Ways and Means Committee recently released the Chairman’s Mark-Up of the Budget Reconciliation Act (the Proposal), which was modified prior to passage by the House.

Included in the Proposal are amendments regarding Qualified Opportunity Zone (QOZ) investments, which will be covered in a separate article and would:

• Extend the QOZ incentive by seven years, permitting investments in QOZs to be made until Dec. 31, 2033.
• Provide for designations of new QOZs for investments made on or after Jan. 1, 2027, including a requirement that at least 33% be rural zones.
• Add a 10% basis step-up for Opportunity Zone investments made after Dec. 31, 2026 that are held for at least five years through 2033.
• Favor designation of rural QOZs over urban QOZs by: – Increasing the five-year 10% basis step-up to a 30% basis step-up for qualified rural investments. – Reducing the Substantial Improvement Requirement from 100% to 50% for rural projects (including data center projects).
• Apply the new rules to QOZ investments made from Jan. 1, 2027 to Dec. 31, 2033. Investments made in 2026 would continue to use the existing rules (including deferral only until Dec. 31, 2026).
• Deferral of capital gain taxes for investments made after Dec. 31, 2026, until Dec. 31, 2033.
• Allow annual deferral until Dec. 31, 2033, of up to $10,000 of ordinary income invested in a Qualified Opportunity Fund after Dec. 31, 2026.
• Add expansive reporting requirements for both Qualified Opportunity Funds and Qualified Opportunity Zone Businesses.
• Impose non-reporting penalties on QOFs ($10,000 for smaller QOFs and $50,000 for larger QOFs up to maximum penalty limits).
• Increase non-reporting penalties for intentional disregard of reporting requirements.

Under the budget reconciliation rules, only a simple majority in the Senate and House are required for passage.

The Proposal includes no changes to carried interest or the corporate or capital gains tax rates, no reduced corporate rate for U.S. manufacturing, no repeal of the stock buyback tax, no repeal of the corporate alternative minimum tax, no limitation on corporate deductions of state or local taxes and does not extend the advanced premium tax credit for Affordable Care Act Marketplace health plans, but is subject to modification in the Senate. Select highlights to date include:

Bonus depreciation

The Proposal extends and modifies bonus depreciation, generally through tax year 2029, generally allowing 100% depreciation in the first year for property acquired and placed in service after Jan. 19, 2025. The Proposal also makes permanent the percentage of completion method for allocation of bonus depreciation to long-term contracts.

State and local taxes

The Proposal increases the cap on deductions for state and local taxes (SALT Cap) but also imposes numerous additional caveats and burdens that would leave many taxpayers worse off than they were in calendar year 2024. Currently, a taxpayer’s deduction for state and local taxes is generally capped at $10,000. The Proposal modified by the House raises the SALT Cap to $40,000 for taxpayers ($20,000 for taxpayers who are married filing separately), with significant new restrictions and caveats.

To the extent a taxpayer’s modified adjusted gross income (MAGI) is greater than $400,000 (or $200,000 in the case of taxpayers who are married filing separately), the proposed SALT deduction is reduced by 20% of the taxpayer’s MAGI above $400,000 (or $200,000 in the case of taxpayers filing separately). The reduction would not phase down below the current cap of $10,000 for most taxpayers (or $5,000 for a married taxpayer filing separately). The new SALT Cap would apply permanently for taxable years after Dec. 31, 2025.

In addition to proposing various changes to prevent some well-known SALT workarounds, the proposal also grants the Secretary of the Treasury regulatory authority to prevent most SALT avoidance efforts. The Proposal disallows deduction of “disallowed specific income taxes” at the entity level for partnerships and S corporations. If the Proposal in its current form becomes law, 2025 would be the last year individuals would benefit from the pass-through entity tax workarounds many partnerships and S corporations have put in place in recent years (generally with IRS approval) – significantly increasing the effective federal tax rate of many partners and S corporation shareholders.

R&D costs

Since 2022, taxpayers have capitalized and amortized U.S.-based research or experimental expenditures ratably over a five-year period and non-U.S.-based research or experimental expenditures ratably over a 15-year period – including costs to develop or improve a product. Examples of costs are the salaries of the people engaged in the research or experimentation efforts, overhead incurred to operate and maintain the facility, and materials and supplies consumed in the course of the research or experimental activities. The requirement to capitalize and amortize these costs has been a source of contention since 2022. .

The Proposal suspends the capitalization of domestic research or experimental expenditures for amounts paid or incurred in taxable years beginning after Dec. 31, 2024, and before Jan. 1, 2030. However, a taxpayer may elect to capitalize and amortize the expenditures by filing an election with its tax return. This is an important election for some taxpayers, who benefit more from FDII (which permanently lowers their tax rate) when they capitalize (a mere timing issue) research and development expenditures. Foreign research or experimental expenditures still must be capitalized and amortized over a 15-year period.

Pass-through entity deduction

Existing law provides a non-corporate taxpayer a deduction for up to 20% of (i) “qualified business income,” including from pass-through entities, (ii) certain real estate investment trust (REIT) dividends, and (iii) certain income of publicly traded partnerships (PTPs). This benefit is available for taxable years beginning after Dec. 21, 2017, but is scheduled to sunset Dec. 31, 2025.

Qualified business income includes certain “qualified” income, gain, deduction and loss with respect to a “qualified trade or business.” Income, gain, deduction or loss is qualified for this purpose if it is effectively connected with the conduct of a trade or business in the United States and is included or allowed in determining taxable income for the applicable taxable year. The statute provides that certain income, gain, deduction and loss is not qualified, including (i) capital gain and loss, dividends, and non-business-related interest income; (ii) reasonable compensation paid by an S corporation; and (iii) guaranteed payments for services and certain other payments. A trade or business can be a qualified trade or business unless it is a “specified service trade or business” (the trade or business of performing services as an employee also does not count). Specified service trades or businesses include law, accounting and consulting firms, as well as investment management and finance-related businesses.

The Proposal amends existing law in several ways, including:

• Making the existing law deduction permanent.
• Increasing the deduction to up to 23% of qualified business income, certain REIT dividends and certain PTP income.
• Providing a new, two-step process for applying the W-2 wages, UBIA, and specified service trade or business phase-in limitations.
• Expanding the definition of combined qualified business income to include certain dividends paid by electing business development companies (“qualified BDC interest dividends”). Qualified BDC interest dividends are dividends from an electing business development company attributable to the company’s net interest income from a qualified trade or business.
• Adjusting the income threshold amounts for inflation for taxable years beginning after 2025. The modifications in the Proposal are effective for taxable years beginning after Dec. 31, 2025.

Individual tax proposed changes

The Proposal would, among other items:

• Make TCJA individual tax rates and the standard deduction permanent, with some helpful adjustments. Specifically, it would permanently extend and increase individual tax bracket values and provide an additional year of inflation indexing; and increase the standard deduction from January 2025 through the end of 2028 by an additional $1,000 ($2,000 for married couples filing jointly);
• Repeal personal exemptions and miscellaneous itemized deductions;
• Increase the child credit from January 2025 through the end of 2028 by $500 to a total of $2,500, and back to $2,200 in 2029 with inflation adjustments thereafter;
• Enhance the standard deduction by $4,000 for seniors for tax years 2025 through 2028 (to help offset taxation of Social Security income);
• Eliminate tax on tips for tax years 2024-2028, generally limited to an income tax deduction for those earning less than $160,000 in 2025;
• Eliminate tax on overtime for tax years 2024-2028, excluding tips and generally limited to an income tax deduction for those earning less than $160,000 in 2025; and
• Allow a deduction for certain car loan interest (only if the vehicle’s final assembly occurs in the United States) for tax years 2025 through 2028.

Immediate expensing for qualified production property

The Proposal contains a special provision for qualified production property, intended to encourage domestic manufacturing and production – allowing for the immediate expensing of costs up to $2.5 million to develop new manufacturing facilities or improve existing manufacturing facilities, with a phaseout threshold that begins to reduce the deductible amount when costs exceed $4 million. Under current law, up to $1 million may be expensed and the phaseout threshold amount is $2.5 million.

Qualified production property means the portion of any nonresidential real property (1) used as an integral part of a qualified production activity; (2) placed in service in the United States; and (3) whose original use begins with the taxpayer. The construction of the property must begin after Dec. 31, 2024, and before Jan. 1, 2030. Qualifying production activities include manufacturing, production (limited to agricultural or chemical) or refining of tangible personal property.

Business interest deductibility

TCJA generally limited the amount of business interest that a taxpayer may deduct to 30% of its “adjusted taxable income” (ATI) – which generally corresponded to its EBITDA. However, for calendar years 2023 and beyond, the defined ATI as EBIT without the DA, which had the impact of severely limiting interest deductibility (i.e., because depreciation and amortization deductions were required to help determine the ATI number against which the 30% limitation was applied). The Proposal again equates ATI with EBITDA for calendar years 2024 through 2029.

Additionally, the TCJA included permanent favorable rules for deducting business interest associated with the financing of dealership inventories, largely designed to benefit auto/truck, boat and farm machinery/equipment dealers, and extends those benefits to recreational vehicle dealers for calendar years 2025 and beyond.

Estate and gift tax exemption proposed changes

Under current law, the federal estate and gift tax exemption is an inflation-adjusted amount of $13.99 million per individual for 2025, though under present law that amount is set to drop to an estimated inflation-adjusted amount of $7.14 million for tax year 2026. The Proposal permanently increases the estate and gift tax exemption to $15 million per individual for tax years 2026 and beyond. This exemption amount is indexed for inflation, meaning for tax years after 2026 the $15 million exemption amount would be increased based on inflation adjustments. The federal generation-skipping transfer tax exemption would be permanently increased to an inflation-indexed amount of $15 million.

New excise tax on international remittance transfers

A new 5% excise tax applies to international remittance transfers from the United States. Such transfers would not include certain small-value transactions. If the excise tax is not paid by the sender, the provider would be required to collect and remit it. The Proposal provides two exceptions for U.S. citizens and nationals. Taxpayers may use a qualified provider that verifies citizenship or claim a refundable tax credit by providing a Social Security number (SSN) and proof of payment to avoid implication of the excise tax. Providers must also report detailed remittance data, including sender information, amounts transferred and taxes collected for credit-eligible individuals.

Exempt organization proposed changes

Increased private foundation investment income tax

The Proposal raises the excise tax on the net investment income of private foundations – estimated to tax $15.9 billion from foundations over the next 10 years – and replaces the current flat 1.39% excise tax on the net investment income with a progressive rate structure from 1.39% for private foundations with assets of less than $50 million to 10% for private foundations with assets of more than $5 billion.

• Substantial tax increases for large foundations: Foundations with significant asset bases, particularly those exceeding $250 million, would face a dramatic increase in their excise tax liability. The highest tier, at 10% , represents a fundamental shift in the tax treatment of the largest private foundations.
• Broader asset base for tax calculation: The inclusion of related organizations’ assets in the calculation may further increase the tax exposure of foundations with complex organizational structures.
• Immediate impact: With the effective date tied to the date of enactment, foundations should promptly assess their current asset levels, organizational relationships and potential tax exposure under the new regime.
• Strategic review recommended: Foundations may wish to review their investment, grantmaking and structural strategies in light of the proposed changes, including the potential impact on endowment management and related entities.

Executive compensation in excess of $1 million

Currently, public companies may not deduct more than $1 million with respect to compensation for a small number of top employees (technically called “covered employees”). The Proposal modifies the rule to apply to the public company’s controlled group. Specifically, (i) a covered employee’s compensation from all controlled group members will be considered; and (ii) in determining who the covered employees are, identifying the five highest-paid employees would be determined by analyzing the entire controlled group’s employee population. The other three criteria for identifying covered employees would still apply based solely on the public company’s employee population.

Conclusion

As the Senate continues to work on tax legislation, new details regarding the various provisions and proposals will emerge. Tax savings may be achieved by those who understand and anticipate expected changes – and take steps regarding their business plans, transaction pipelines, restructurings, operational affairs and estate plans accordingly.

Phil Jelsma, partner and tax practice chair, and Ulrick Matsunaga‘s article was published in The Los Angeles Daily Journal and The Daily Transcript (both subscriber only).