After almost a year of a Republican-controlled Congress trying to pass major reform legislation as part of its legislative agenda, the House and Senate appear poised to send a sweeping tax reform package for President Trump’s signature. The Tax Cuts and Jobs Act (TCJA) passed the full House, and the Senate’s version of the legislation passed in the early morning hours of December 2. Several last-minute changes to the Senate bill widened the differences between the two versions of the tax reform package, and while the House insisted that a Conference Committee be convened (rather than having the House try to pass the Senate bill) momentum remains to have negotiations finished before Christmas. Earlier this week House leadership on both sides named its conferees. Senate Republicans announced their conferees mid-week and Senate Democrats are expected to do the same on their side of the aisle shortly.
Despite the organization of a pro forma Conference Committee, deliberations on the tax package are being expedited in hopes of everything being done by December 15 or December 22, at the latest. Even before the Senate passed its bill, key lawmakers from both chambers were already working behind the scenes on how to handle differences in the legislation. Those members, which include Senate Majority Leader Mitch McConnell (R-KY), House Speaker Paul Ryan (R-WI) and House Ways & Means Chairman Kevin Brady (R-TX), are the most important in resolving the outstanding issues and will do so with the goal of having a final bill that can pass the House and the Senate. The following provides a summary of key provisions in the House and Senate bills and how many of the differences between the provisions may be resolved. For context, the following should be read and considered in light of these things: (i) Congress has $1.5 trillion in net tax cuts to work with, measured over the ten year budget window; (ii) Republicans are trying their best to make this genuine reform, meaning overall simplification, permanence, and an end to many of the peculiar nuances of the Internal Revenue Code that are either needlessly complex or are reasonably seen as special interest giveaways; and (iii) under the “Byrd rule,” which allows legislation to be passed that is not subject to a filibuster and needs only 51 votes, the Senate version of the tax bill can only increase the deficit by $1.5 trillion in the first ten years and cannot increase the national debt outside that window, which explains why many provisions in the Senate bill have “sunsets.”
The following are some of the most significant issues for individual taxpayers:
- Individual Tax Rates: The House version of the TCJA reduces the number of marginal rates from seven to four, in an effort at simplification, and makes the brackets permanent. The Senate version keeps the number of marginal rates at seven but generally raises the brackets when higher marginal rates apply. It also lowers the top marginal rate from the current 39.6% to 38.5%. The brackets in the Senate bill expire at the end of 2025 to comply with the Senate rule discussed above. In all likelihood, one or both concepts will be in any final bill.
- Alternative Minimum Tax: While both houses are looking to do something with the AMT, the House proposes a full repeal while the Senate proposes raising the exemption amount and the phaseout amount. In the end, something likely will be done to reduce the number of individuals subject to the AMT.
- Simplification: Both the House and Senate propose to roughly double the “standard” deduction, effectively reducing the number of individuals who itemize deductions. We suspect this change will make it into any final bill. Where the houses differ is on changes to itemized deductions. For example, both versions of the TCJA reduce the benefit of (i) state and local tax deductions and (ii) mortgage interest deductions. It is difficult to project how these other differences will be resolved, but look for some substantial changes to itemized deductions, particularly for higher earning individuals.
- Pass-through Entity Income: As described below, an almost certain (and significant) change to business taxes will be a reduction in the highest marginal tax rate for corporations. But, with the majority of businesses in the U.S. being taxed as “pass-throughs” (i.e., S corporations, partnerships, and entities such as limited liability companies taxed as partnerships) something must be done to provide relief to these owners. This has been arguably the biggest hurdle to tax reform (and nearly cost Republicans the vote of Senator Ron Johnson (R-WI)) and remains a point where the House and Senate are far apart. Even a high-level summary of each proposal is beyond the scope of this First Alert, but look for significant tax relief for pass-through business owners (with a possible exception for pass-through businesses that are service oriented, such as law and accounting firms).
- Estate Tax: Both versions of the TCJA would, for the time being, double the exemption amount to approximately $22 million for couples (when adjusted for inflation). The House version would eventually repeal the estate tax while the Senate version would not. The Senate also would eventually bring the exemption amount back down to the current amount in one of its many “sunset” provisions. Whether an outright repeal will end up in any final bill is difficult to predict.
The following are some of the most significant issues for businesses, including corporations:
- Corporate Tax Rate: If one thing is certain to emerge from tax reform it is a reduction in the corporate tax rate, with both versions of the bill calling for a flat 20% rate. The House version of the bill would have this change effective immediately while the Senate version would have the change effective in 2019 (to reduce the revenue losses due to this change in the ten-year budget window). Notably, this is one of the few revisions in the Senate version of the TCJA that is not subject to a sunset.
- Alternative Minimum Tax: Unlike individuals, corporations subject to the AMT do not appear to be guaranteed any relief. The House version of the TCJA repeals the AMT while, in a last-minute change, the Senate version keeps the tax as is. The possible reinstatement of the corporate alternative minimum tax elicited blowback from the House and businesses, including the U.S. Chamber of Commerce, and is one of the big reasons why the House would have unlikely been able to pass the Senate version of the bill. House tax writers have vowed to abolish it, believing it undermines pro-growth provisions kept in current law such as tax credits for research and development. It remains a major issue and it is difficult to predict the outcome of this difference at this time.
- “Carried Interest”: Both versions of the TCJA would impose a three-year holding period (as opposed to one year) for certain holders of “carried interests” to enjoy the reduced rates for long-term capital gains.
- Nonqualified Deferred Compensation/Stock Options: The initial House version of the TCJA repealed Section 409A and proposed replacing it with a new Section 409B to govern nonqualified deferred compensation generally. An early Senate version proposed taxing stock options when they vest, as opposed to when exercised. Both proposals received, at best, lukewarm reactions and are now removed. We do not foresee any significant changes in this area.
- Accelerated Depreciation/Expensing: Both versions of the TCJA call for accelerated depreciation/expensing of property for businesses as a form of economic stimulus. It is almost certain some form of this will make it into a final bill.
- Deductibility of Interest: Both versions of the TCJA call for reduced deductibility of interest expense. Currently fully deductible, both would phase out the deduction for interest in excess of a certain threshold amount (generally speaking, 30% of business income). Both versions, however, provide exemptions for small businesses (as determined based on gross receipts, $25 million or less in the House version, $15 million or less in the Senate version). Look for some form of this provision to be in any final bill.
- Foreign Operations: A long-time goal of Republicans has been moving from a “world-wide” system of taxation to a “territorial” system. Look for this change in some form, so that, generally speaking, domestic companies are not taxed on activities in foreign jurisdictions.
With Republican majorities in both the House and Senate (and a Republican occupying the White House), tax reform may appear to be a done deal. But, there are many contentious issues remaining and, as the failure to repeal Obamacare demonstrated, there are more than enough Republican lawmakers who are willing to buck the party goals for one reason or another. It is worth noting that the only bipartisan vote on tax reform has been against it, with Republican Bob Corker of Tennessee (a well-known adversary of President Trump) joining with every Democrat and Independent in voting against the TCJA in the Senate. Republicans were not unanimous in the House either. However, there does not appear to be anything that would derail Conference Committee proceedings, especially since House and Senate leaders worked for months to make sure they were on the same page before their respective bills were unveiled. The Senate bill has already moved closer to the House version, most notably on the state and local tax deduction compromise. In addition, the Senate likely has the stronger hand in the negotiations due to the budget reconciliation rules and tighter margins. However, the House never likes to be rolled and the Freedom Caucus will continue to try to use its three dozen votes as leverage on certain issues. Bottom line: tax reform gets passed and signed into law, but stay tuned on details because the next two weeks will be interesting.
"With Republican majorities in both the House and Senate (and a Republican occupying the White House), tax reform may appear to be a done deal. But, there are many contentious issues remaining and, as the failure to repeal Obamacare demonstrated, there are more than enough Republican lawmakers who are willing to buck the party goals for one reason or another... Bottom line: tax reform gets passed and signed into law, but stay tuned on details because the next two weeks will be interesting."