Senate Tax Reform Draft: Sweeping Changes, Obstacles Loom

On Monday, Senator Crapo released much-anticipated initial draft legislation from the Senate Finance Committee for the One Big Beautiful Bill Act reconciliation bill (the Senate Bill). This release marks a pivotal step in the ongoing legislative process as it adopts many of the tax priorities from the House-passed version (the House Bill) that we discussed in our prior alert. However, the Senate Bill introduces drastic changes, particularly regarding the deduction limit for state and local taxes, additional international tax reforms, and Medicaid. The next steps include ongoing negotiations among Republicans, both within the Senate and with House colleagues, as well as a review of the bill by the Senate Parliamentarian to determine whether any provisions are not allowed in a reconciliation bill (a process referred to as the Byrd bath). Nevertheless, we believe it is crucial to highlight the key tax provisions of the Senate Bill as they could play a significant role in shaping the 2025 tax reform legislation, with a mix of potentially favorable as well as adverse impacts for different taxpayers. In this alert, we aim to provide you with a summary of some of the key provisions and their potential implications.

TCJA Provisions (Made Permanent Beginning in 2025)

• Research and Experimental (R&E) Costs: Permits the immediate expensing of certain domestic research and experimental costs, with an option to amortize these expenditures (§§174 and 174A), like the House Bill.
• Bonus Depreciation: Reinstates 100 percent bonus depreciation for certain property (§168(k)).
• Business Interest Expense Deduction: Reverts to the 30 percent limit on business interest expense (§163(j)) that is based on an EBITDA-like calculation instead of an EBIT-like calculation. Additionally, the scope of interest subject to the limitation is modified:
  • Excludes interest for floor plan financing for certain trailers and campers.
  • Includes capitalized interest, except for interest attributable to a straddle (§263(g)) or subject to UNICAP (§263A).
  • Calculates the limitation without including subpart F income (§951), global intangible low-taxed income (GILTI) (§951A), and the gross up for deemed paid foreign taxes (§78) (collectively, the “international tax income”).

A&M Insight: The Senate Bill largely mirrors the House Bill’s provisions for expensing of R&E costs and for bonus depreciation but proposes to make these TCJA provisions permanent, rather than expiring after 2029. This offers significant planning opportunities. However, the changes in the Senate Bill to the business interest expense limitation could have substantial implications, necessitating a thorough review of the impact on borrowing costs. While the Senate Bill proposes to make the return to the EBITDA-like calculation permanent, the exclusion of international tax income disfavors US multinationals owning foreign corporations. Distributions from US companies in the form of dividends are included in the limitation calculation, while there would be no equivalent treatment for foreign corporations. This discrepancy could affect the financial strategies and optimal legal entity organization structure for multinational companies. It is crucial for all taxpayers to reassess their tax planning and financing strategies to mitigate potential adverse effects.

Corporate Tax Provisions

Like the House Bill, provisions in the Senate Bill specifically affecting corporations are limited, and include, for example, proposed changes to the limitation on the deductibility of compensation for for-profit corporations (§162(m)). As in the House Bill, the Senate Bill provides that starting in 2026, compensation paid by all members of a controlled group will be aggregated for purposes of applying the $1 million deduction limitation. Additionally, the determination of the five highest compensated employees during the taxable year (excluding current and historic CEOs, CFOs, and the three highest compensated officers who were not CEOs or CFOs for any given year), which first applies in 2027, will be based on aggregate compensation paid to each individual by all members of the controlled group, potentially changing which employees’ compensation is subject to the deduction limitation. Any resulting limitation on deductibility would be allocated pro-rata across all controlled group members paying compensation to the relevant individuals.

International Tax Provisions

• Increase of Tax on Foreign Persons:

  The Senate Bill includes a similar provision as the House Bill (as discussed in our prior alert on the provision), which could dramatically impact the US tax liability of any taxpayer that is resident in a foreign country that imposes certain “unfair foreign taxes” and of any domestic corporation that is controlled by such residents (§899). The Senate Bill makes numerous modifications to the House Bill version, including:

  • Reduces the maximum tax increase to 15 percent (instead of 20 percent in the House Bill) and makes clear that taxpayers that are not subject to tax by reason of an exemption or exception, or are subject to a tax rate equal to zero, are subject to a maximum tax rate of 15 percent.
  • Removes diverted profits taxes (DPTs) from the definition of “unfair foreign taxes” and clarifies that certain items are excluded from the scope of §899, such as portfolio interest, short-term original issue discount, interest on bank deposits, and regulated investment company dividends.
  • Modifies the application of the super charged BEAT provisions and expands their application to include any US branch of a non-publicly held foreign corporation if such corporation is an applicable person with respect to an offending foreign country.
  • Delays the effective date to taxable years beginning one year after the date of enactment (compared to only 90 days in the House Bill).

A&M Insight: The reduction of the potential tax rate, clarification as to the application of the tax to certain income, and delay in effective date are generally viewed as taxpayer favorable changes.  Additionally, the Senate Bill provides that §899 would not apply if a tax rate is doubled due to a Presidential proclamation under §891, which is amended to use the definitions of discriminatory and extraterritorial taxes in §899. A revitalized §891 gives the administration the option of issuing a proclamation under §891 in 2026 to engage with selected countries (e.g., Canada on its DST) while using the threat of §899 taking effect in 2027 to reach a global agreement with the OECD on Pillar 2 while avoiding the significant compliance costs that administering §899 starting next year would entail.

• Change in Tax Rates:

  • Base Erosion and Anti-Abuse Tax (BEAT): The minimum tax rate on base erosion payments (§59A), which are payments made to foreign affiliates that can reduce a company’s tax liability, is fixed at 14 percent (compared to the House Bill of 10.1 percent). The Senate Bill also applies a 2 percent base erosion percentage to all taxpayers (currently 3 percent for non-banks and non-securities dealers) for purposes of determining whether a taxpayer may be subject to BEAT and makes modifications to what constitutes a base erosion payment.
  • International Tax Rate Increases: The deduction (§250) associated with GILTI and Foreign-Derived Intangible Income (FDII) is modified to result in an effective tax rate of 14 percent for each. Additionally, the Senate Bill modifies the GILTI and FDII calculation by eliminating the adjustments that are currently included in the calculations relating to tangible income returns.

• Additional International Provisions:

  • Consistent with prior proposals, the Senate Bill would generally reinstate the prohibition on the application of downward attribution to determine controlled foreign corporation (CFC) status, while adding a new section to subpart F to preserve the rule when taxing foreign controlled US shareholders. (See our prior alert discussing this proposal).
  • The Senate Bill also modifies several subpart F rules by: (1) making the exclusion for certain CFC-to-CFC dividends permanent, (2) requiring that the CFC’s taxable year match the taxable year of the majority US shareholder, and (3) adjusting the pro rata share rules for subpart F (and GILTI) purposes to account for changes in shareholder ownership during the taxable year.
  • The Senate Bill modifies the calculation of the foreign tax credits associated with GILTI and the amount of deemed paid taxes associated with GILTI tested income. Additionally, the Senate Bill permits a taxpayer to treat up to 50 percent of the income from the sale of certain inventory property as foreign source income.

A&M Insight: The proposed changes to GILTI will increase the effective US tax rate on CFC income, which may be helpful in OECD discussions to exclude the United States from the scope of Pillar 2. However, modifications to the US foreign tax credit rules for GILTI and FDII may offset some of these impacts. The BEAT changes will likely raise costs for in-scope taxpayers, but the new “high tax exception” could reduce the overall applicability of the BEAT. Taxpayers using foreign tax credits to mitigate their US tax liability of GILTI inclusions and under the FDII regime will benefit from these proposed changes. Further, the revisions to the CFC rules attempt to continue to neutralize the tax implications of certain CFC out-from-under transactions (moving non-US entities out from under the US entity into local entities within the country in which they operate).

Other Business Tax Provisions

• Bonus Depreciation: Allows 100 percent bonus depreciation for certain production, manufacturing, and refinery facilities (§168(n)) effective for property placed in service after the date of enactment and before January 1, 2031, subject to additional requirements.
• Qualified Business Income (QBI): Makes the 20 percent deduction for certain business income (§199A) permanent and increases the deduction phase-out thresholds for taxpayers subject to the wage and investment limitation and for specified service trades or businesses.
• Opportunity Zones: Makes qualified opportunity zones permanent with a rolling ten-year designation cycle beginning in 2027 and entitles taxpayers to an incremental step-up in basis beginning in year 1. Additionally, the provision establishes a “qualified rural opportunity funds” category that will potentially triple a taxpayer’s step-up in basis and reduce the required improvement percentage to 50 percent.

A&M Insight: Unlike the House Bill, the Senate Bill maintains the current 20 percent deduction for QBI, while softening the proposed restrictions for specified service trades or businesses but being more restrictive than the House Bill. Additionally, the expansion of opportunity zones, including allowing for some gain exclusion beginning after only one year of investment will likely spark significant interest in the program. However, like the House Bill, the opportunity zones provision requires careful planning as it only applies to amounts invested in a qualified opportunity fund beginning in 2027.

Green Energy Provisions

The Senate Bill introduces significant changes to many green energy incentives, including nuanced adjustments, enhancements, and phaseouts:

• Termination of Credits: Credits for clean vehicles (§§25C, 25D, 25E, 30C, 30D, and 45W) and new home energy efficiency (§45L) generally terminate within 90 days to 12 months after enactment, and the credit for clean hydrogen (§45V) terminates for facilities beginning construction after December 31, 2025.
• Reduction of Major Green Energy Incentives: Eligibility for investment and production tax credits (§§48E and 45Y) for wind and solar projects is reduced, requiring projects to begin construction by 2027 to qualify for any credits (with rate phaseouts for projects that begin construction in 2026 (60 percent of base rates) and 2027 (20 percent of base rates)). Other energy sources (e.g., energy storage, hydropower, geothermal, nuclear) retain full credits if construction begins by the end of 2033.
• FEOC (Foreign Entity of Concern) Revisions: FEOC rules limit the availability of the investment and production tax credits (§§48E and 45Y) and the advanced manufacturing tax credit (§45X) where certain foreign entities (i) meet ownership thresholds, (ii) meet control thresholds, or (iii) are the source of manufactured products and components for the construction of generation facilities or the production of eligible components.
• Limited Expansion for Clean Fuels and Carbon Capture: The clean fuel credit (§45Z) is extended through 2031 (with a rate decrease for Sustainable Aviation Fuel (SAF) after 2025); certain carbon capture projects eligible for a higher carbon capture credit (§45Q) rate.
• Transferability of Credits: The ability to transfer credits for cash remains, with the restriction that buyers cannot be certain foreign entities.

A&M Insight: The changes in the Senate Bill generally are a welcome adjustment compared to the House Bill. The reduction of eligibility for investment and production tax credits is primarily limited to wind and solar projects, without requiring projects to be placed in service by the end of 2028. Maintaining transferability will help sustain green energy credits, and the corresponding projects and markets. However, the Senate Bill includes additional restrictions, such as limiting assistance from foreign entities of concern. Many Republicans have expressed that the Senate Bill remains too generous with green energy credits, suggesting that further restrictions may be imposed in the final bill.

Individual Taxes

• Avoidance of Tax Rate Increases: Makes the current individual tax rates permanent.
• Deduction for State and Local Tax (SALT): Retains the $10,000 cap on SALT deductions (subject to further negotiations among Republicans) and introduces a higher cap on a partner’s or S corporation shareholder’s separately stated share of passthrough entity taxes (PTET) (greater of 50% of the individual share of the entity’s taxes or 40,000 for joint filers), among other changes.
• Limitation on Itemized Deductions: Beginning in 2026, sets the maximum benefit for itemized deductions (other than SALT) at 35 percent, and the maximum benefit for SALT at 32 percent (in contrast to the current maximum benefit of 37 percent).
• High-Net-Worth Benefits: Sets the gift and estate tax exemption for 2026 at $15 million, with subsequent adjustments for inflation, like the House Bill.
• Gain Exclusion for Small Business Stock: Expands the gain exclusion rules for the sale of qualified small business stock (QSBS) (§1202) by (1) allowing 50 percent gain exclusion if stock is held for at least three years; 75 percent if held for four years; and 100 percent if held for at least five years and (2) increasing the limit on the eligible gain per issuer to the greater of $15 million (from $10 million) or ten times the taxpayer’s original basis in the shares.
• Exemptions and Credits: Provides for the reduction in certain individual taxes (e.g., no tax on tip income or overtime pay, along with tax credits that advance certain social priorities).

Like the House Bill, the Senate Bill does not include much-discussed changes to the rules governing carried interest.

A&M Insight: The Senate Bill contains several individual provisions, but the most important is the limitation on SALT deductions (including the limitation on PTET). This provision remains a contentious issue, with some House Republicans advocating for at least a $40,000 cap and some Senate Republications pushing for the elimination of the deduction altogether. The current provision in the Senate Bill — noted as a placeholder and subject to further negotiations — does not treat service partnerships differently than other partnerships for purposes of PTET benefits, as does the provision in the House Bill. The expanded gain exclusion rules for QSBS are a notable development offering substantial tax benefits for investors. Because many facets of QSBS gain exclusion require guidance, careful planning is necessary to ensure taxpayers qualify for the benefits of the provision.

A&M Tax Says

The Republicans have slim majorities in both the House and the Senate. The Senate Bill, which proposes significant amendments to tax and non-tax (e.g., Medicaid) provisions, faces considerable hurdles. In the Senate, deficit hawks and those advocating for permanent benefits are on a collision course. In the House, due in large part to the SALT limitation, the Senate Bill appears to have no chance of being adopted. Therefore, while the proposed changes, especially the international tax provisions, are noteworthy, the path to enactment remains uncertain. Nonetheless, analysis of the provisions and their impact is important because once a provision is suggested, it could be adopted in subsequent legislation. Taxpayers should stay informed about potential revisions and legislative developments. If you would like to discuss how the evolving legislative and regulatory landscape could impact your business strategies and tax planning, please feel free to reach out to Kevin M. Jacobs of our National Tax Office.