By SEMA Washington, D.C., Staff
Republican Congressional leaders and the Trump Administration have introduced legislation to overhaul the U.S. tax code. The measure is being debated in the House Ways and Means Committee with the goal of having it be approved by the U.S. House of Representatives by the end of November. Republican leaders in the U.S. Senate are crafting their own version of the tax bill to be debated in the near future. The goal is to merge the House/Senate bills by the end of the year.
In order to expand the voice of SEMA members on Capitol Hill, SEMA has been a longstanding member of the Small Business Legislative Council (SBLC). It is a leading advocate on topics that impact small businesses, especially tax issues. The SBLC has prepared the following analysis of the House bill (below). For more information, contact Eric Snyder at erics@sema.org.
How Would Small Businesses and Their Owners Fare Under H.R. 1 “The Tax Cuts and Jobs Act” and What Happens Next?
While this analysis focuses on the House tax reform bill, the Tax Cuts and Jobs Act (H.R.1), it is important to recognize that this piece of legislation is just the first stop towards a final bill. The Senate Finance Committee will be releasing its own draft tax reform bill which may differ on some issues.
Looking at things from a 10-mile high perspective, two-thirds of the tax cuts ($900 billion over the next ten years) in H.R. 1 would benefit corporations and one-third would benefit individuals.
Do Any Taxpayers End Up Worse Under H.R. 1?
A major goal of the House tax reform legislation is to have lower rates while broadening the tax base (by eliminating tax credits and deductions). It turns out though that single taxpayers with taxable income between $200,000 and $424,950 and married taxpayers with income between $260,000 and $424,950 would actually have their tax rate increased by 2% from 33% to 35%. Strangely, this is also the only group that would get hit with the marriage penalty.
Most of the capital gains and dividend rates remain the same except for single taxpayers with gain from capital assets or dividends of between $424,950 and $426,700—these taxpayers would see a 5% rate increase from 15% to 20%.
As a bottom line, if an individual or a married couple has a significant amount of medical expenses, mortgage interest (existing loans would be grandfathered and subject to the old rules), real-estate taxes (under H.R.1 the deduction would be capped at $10,000), and/or state and local income taxes, they could end up worse off under this new bill.
The bill would increase the standard deduction next year from $13,000 to $24,400. This standard deduction would be indexed to a measure of inflation known as the “chained CPI”, which will grow more slowly than the inflation factor utilized today. While the standard deduction is increased, with that would come the repeal of the personal exemption that in the past was claimed for each member of the household. The loss of the personal exemption could hurt families with even just two children—under current law, in 2018 a married couple with two children would receive a $13,000 standard deduction with four personal exemptions of $4,150 for a total exemption of income from federal income taxes of $29,600, whereas under H.R. 1 only $24,400 would be exempt from federal income tax. Obviously, the more children a middle to upper-middle income family has, the more the loss of the personal exemption would hurt. The loss of personal exemptions is offset at least somewhat, but not entirely, by an increase in the child tax credit from $1,000 to $1,600 and an increase in the income limits where the child tax credits phase out to $115,000 (up from $75,000) for single taxpayers and $230,000 (up from $110,000) for married taxpayers. There is also a new credit for non-child dependents (the new “family flexibility credit”) of $300 but this will sunset in 2022.
Also on the child and dependent front, the ability of employers to offer tax-advantaged dependent care Flexible savings accounts was initially eliminated immediately under H.R. 1 until Monday when an amendment introduced by Chairman Brady of Ways and Means modified the bill to provide for such FSAs to continue until 2022. In short, middle to upper-middle income taxpayers with children would see a lot of changes under this proposal.
Another big change that taxpayers would see under H.R. 1 is a limiting of the mortgage interest deduction to $500,000 of acquisition debt (no deduction allowed for home equity loans), which will significantly increase the cost of higher-end homes or homes in more expensive regions. It is not hard to imagine this provision triggering a housing crash or a loss of value with respect to these types of homes and/or people shifting to renting high-end homes rather than purchasing them.
One of the most controversial and complex provisions in the tax bill is the new pass-through business income tax rate. For owners in a pass-through entity who actually work in the business, the default provision is that 30% of the income is deemed to be attributable to the capital of the business and thus taxed at a new 25% tax rate while the remaining 70% is subject to the normal income tax rates. There is a far more complicated formula for small business owners who choose to apply a facts and circumstances test to show that more than 30% of the income from the business is attributable to capital they have invested and thus will be taxed at the 25% tax rate. For owners of personal service organizations, such as lawyers, doctors, accountants, engineers, actuaries and consultants, the default presumption for active business income would be 0% not 30%.
Not only will this provision add tremendous complexity to the tax code but it also creates a new major disparity in tax rates between C Corps (20%) and pass-through entities (a blend of 25% and the owner’s personal income tax rate). This differential is far worse than what exists today. Thus, instead of closing the gap between the C corp and pass-through entities, H.R. 1 actually makes the gap far worse. This provision is why many small business owners who work in their own businesses believe that the bill discriminates against them. Meanwhile folks who do not work in the pass-through, so-called “passive” owners, will receive the 25% rate on all income from the business.
[As an aside, the bill provides significant benefits to foreign investors. This is because of the drop in the C corporate tax rate from 35% to 20%. Economists tell us that corporate tax cuts as a general rule tend to benefit those who own stock in a corporation. According to the Institute on Taxation and Economic Policy, today foreign investors own approximately 35% of stock in American corporations. It is estimated by the Institute on Taxation and Economic Policy that foreign investors would receive $47 billion in benefits from the House bill in 2018 and in contrast, $38 billion in benefits would go to the bottom three-fifths of Americans.]
Another potential problem with the pass-through provision is it appears that, absent a modification to the bill, contributions made by owners and/or their pass-through business to a 401(k) or other qualified retirement plan could be offset against the 30% tranche. This means that by contributing to a plan business owners would be foregoing a 25% rate on that money to instead put it into in a plan that, when taken out, would be taxed at the much higher individual rate. This would turn the tax incentives of these plans on their head and create a disincentive for small business owners to sponsor and contribute to a qualified retirement plan. Many small business groups, including the SBLC, are working to get language inserted into the bill which will fix this problem.
The bill would also bring with it substantial changes to deferred compensation rules. For non-profit associations, 457(b) plans would be eliminated. 457(f) plans could only have a substantial risk of forfeiture based on the future performance of substantial services. 409A would be repealed and replaced with a new 409B. This new tax code section would change the existing rules on deferred compensation plans so that the vast majority of these plans would no longer exist. Existing deferred compensation plans that were established based on pre-2018 service would be grandfathered until the last tax year beginning before 2026.
What Are the Advantages of the New Tax Bill?
While there are a number of controversial and potentially problematic provisions in the bill, depending on what kind of taxpayer you are looking at, the bill also brings definite advantages.
C corporate rates drop immediately to 20% (though, as noted above, this comes at the expense of increasing the disparity with pass-throughs).
The alternative minimum tax (AMT) is repealed, which is likely to help upper-middle income and wealthy taxpayers and would definitely simplify the tax code.
The bill would also increase the federal estate tax exemption (as well as the generation-skipping transfer tax exemption) in 2018 for single individuals from $5.6 million to $11.2 million and for married couples from $11.2 million to $22.4 million which would be a major help for those small business owners who had a higher estate than the current exemption amounts. Starting in 2023, the estate tax and the generation-skipping transfer tax are scheduled to be repealed in their entirety. The step-up in basis is preserved in this bill which will help the heirs of any deceased person who had assets that had appreciated significantly during his/her life. The increase in the exemption amounts culminating with repeal will be of some help to those upper-middle income taxpayers or those in the lower range of wealthy whose estates exceed the amount of the exemption today. It will be an enormous help to the extraordinarily wealthy.
Companies would be able to immediately write off the full cost of investments in their businesses, starting with assets purchased after September 28, 2017 and before January 1, 2023. Moreover, companies with average gross receipts of $25 million or less will be able to continue to deduct business interest. For those with average gross receipts of greater than $25 million, the business interest deduction will be limited to 30% of adjusted gross income.
The section 179 deduction is expanded dramatically from $500,000 to $5 million and has an increased phaseout threshold, and the research and development credit is retained as is the low-income housing credit.
Finally, H.R. 1 would increase the availability of the cash method of accounting by raising the current $5 million average gross receipts ceiling to $25 million.
Conclusions
As noted above, the proposals in H.R. 1 are just the beginning of the tax reform efforts. As we saw with the health-care fight earlier this year, passage of tax reform will hinge on whether the Republican leadership can assemble sufficient support in the Senate. Because of this, we expect the Senate bill to be the greater driver of the process, with the current House bill serving as more of a test balloon for certain provisions. While there is a great deal of momentum behind tax reform at this point, there have also been some significant groups, including Republican members in places with high state and local income taxes (whose constituents could be negatively impacted by H.R. 1 in its current form), who have raised concerns about the bill. Moreover, it is no secret that the current proposal would significantly increase the federal deficit, which may pose a concern for the budget hawks.