The House Ways and Means Committee and President Trump have released more details on the Republicans’ joint tax reform plan, agreed to in principle by the Big Six, made up of key Congressional and Administration tax officials. (See our earlier article on the plan.) The latest iteration, the United Framework for Fixing our Broken Tax Code, includes a 25% tax rate for partnerships and S Corporations and a 20% corporate tax rate. Also included is immediate expensing of the cost of depreciable business assets for five years. Although no legislative language has been released, the structure of the proposal is coming into focus and important themes have started to emerge.
As the likelihood of tax reform increases, it is time for you to start considering what the proposed changes will mean for your business going forward. Let’s share our observations with you. Below is a table showing the proposed changes in key areas of the plan followed by our comments.
Passthrough Entity Rate of 25%
|A 25% maximum tax rate would apply to business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations. The plan will include rules to prevent “wealthy individuals” from running their income through the business to avoid the higher top individual rate of 33%.
Comments: Although this change could result in significant tax savings for some businesses, the key will be the carve-outs Congress decides on. You can expect that most businesses that provide professional services, such as law firms, engineering companies, architects, accountants, etc., will be prevented from taking advantage of the lower passthrough rate.
|Corporate Tax Rate of 20%||The plan reduces the corporate tax rate to 20% – which is below the 22.5% average of the industrialized world. It also eliminates the corporate alternative minimum tax (AMT).
Comments: While the cut in the corporate tax rate from the current 35% to 20% would make U.S. companies more competitive in global business, some businesses could pay more. Even though the corporate rate is now 35%, the actual rate paid by corporations varies significantly by industry, depending on the special tax breaks that apply. Industries now favored in the tax Code could see an increase in their corporate taxes if their special tax credits and deductions are eliminated. (See discussion below.)
|Full Expensing for Capital Investments||The plan would allow all businesses to immediately write off (or “expense”) the cost of new investments in depreciable assets other than structures for at least five years. Full expensing would replace the current rules that allow expensing of $500,000 for smaller companies, 50% bonus depreciation, and regular MACRS depreciation based on class lives.
Comments: Full expensing would simplify the tax Code by abolishing the need to keep track of complicated depreciation rules. However, limiting full expensing to five years could have unintended effects. Businesses would be incentivized to overspend in the five-year period, which may not necessarily match their true need for business assets. Also, larger corporations would benefit the most because smaller companies, those that do not purchase more than $2 million per year in business assets, already get a generous expensing write-off under current law.
Businesses also would be subject to recapture tax upon the sale of fully-expensed assets. The recapture rules increase the tax rates on gains from sale of business assets to the extent depreciation was taken.
Finally, businesses may not have enough income to offset, so net operating losses could grow, complicating a business’s financial picture. It is important to understand that the full expensing is front-loaded, with an immediate deduction in the first year and no deductions in later years unless the write-offs result in net operating losses.
|Corporate Interest Deduction Limits||The deduction for net interest expense incurred by C corporations will be partially limited. The plan does not address interest expense paid by non-corporate taxpayers.
Comments: The plan’s sponsors have included an interest limitation for a couple of reasons. One reason is to balance the treatment of debt and equity financing. Currently, debt financing by corporations is completely deductible as interest expense while equity financing is not.
The other reason for limiting corporate interest expense is to prevent the tax arbitrage that occurs when a business takes out a loan to buy a business asset, deducts the full cost of the asset, and then deducts the interest on the loan.
|Abolishing or Limiting Business Deductions and Credits||As a trade-off for lower rates, the plan states that many business deductions, credits, and other special industry tax breaks will be cut back or abolished. The Section 199 domestic production deduction is one example.
The proposed plan specifically preserves the research and development (R&D) credit and the low-income housing credit.
Comment: Restricting business tax breaks will be one of the biggest challenges in passing tax reform. Once a tax benefit is given in the Code, it is close to impossible to get rid of it because a Congressional constituency/trade group/lobbying industry usually has grown up around it. Even with lower rates, businesses that currently have a low effective tax rate because of special tax breaks could see their tax bill increase if these write-offs are abolished.
|International Business Activities and Offshore Profits||The framework would replace the existing, worldwide tax system with a territorial system, with a 100% exemption for dividends from foreign subsidiaries. The exemption would only be available to U.S. parents that own at least a 10% stake in the foreign subsidiary.
To transition to this new system, the plan would tax all profits now held overseas at a one-time low rate, possibly between 8.75% and 10%. Payment of the tax liability will be spread out over several years. To prevent companies from shifting profits to tax havens going forward, the plan includes rules to tax at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations that are held offshore.
Comments: The proposals for taxation of foreign income would bring the U.S.’s international tax system in line with that of our major trading partners and much of the rest of the industrialized world. It also would encourage companies to keep jobs and capital in the U.S.
The tricky part is in the transition. Corporations with large amounts of income held offshore will be writing big checks to the government, so the length of time businesses have to pay the one-time transition tax will be very important.
Also, businesses now have been able to avoid any tax by keeping profits offshore. Under the new plan, complete tax avoidance will not be possible. Companies that legitimately want to invest profits overseas will have to pay some U.S. tax, and the rules could get complex.
|Capital Gains and Investment Income||No provision
Comments: Interestingly, the plan does not discuss capital gains and investment income for either individuals or businesses. Earlier plans, such as the House GOP Better Way plan, called for a 16.5% capital gains rate, while candidate Trump’s plan preserved the 20% capital gains rate for the highest bracket taxpayers.
Investment income has been taxed at a lower rate than wage income for many years. If the lower dividend rates are not preserved, the effect of the C Corporation rate reduction will be undercut. Higher capital gains rates could discourage investment.
With the passthrough rate set at 25% and the corporate rate at 20%, it will be important for Congress to coordinate the capital gains and dividend rates with the lower corporate and passthrough income rates.
|Temporary v. Permanent Changes||The latest tax reform framework does not address whether the authors plan to seek permanent changes or temporary changes. The framework states that full expensing will last “for at least five years.”
Comments: The Congressional budget rules set timetables for legislation and strict rules about revenue shortfalls over pre-set benchmarks. If the changes wanted by the Big Six leaders cost too much, they could adopt a more limited time horizon for the reform plan.
The fact that the framework authors included a five-year limit on expensing suggests that Republican leaders could be contemplating a tax plan of limited duration. The uncertainty caused by temporary tax measures is harmful to business planning and confounding to investors. Once effective dates are released, the important analysis of potential long-term effects will begin.
About the Author
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax Professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.