Congressional Republicans have reached an agreement on a tax reform proposal that will dramatically change the US tax code. The final agreement will have widespread implications for small business, partnerships, and multinational corporations.
The legislation is based on US House of Representatives and US Senate tax bills that aimed to reduce taxes, stimulate economic growth, and create jobs. While there is considerable debate on the ability of the tax bill to accomplish each of these objectives and the broader implications of the $1.5 trillion potential cost of the bill, it is clear that Congressional Republicans and the White House are on the verge of fulfilling one of their top legislative goals before the end of 2017. As the final tax agreement advances to the House and the Senate for a vote, Republicans leaders will work to secure a sufficient number of votes to pass the legislation in the face of unified opposition from Congressional Democrats.
Major Contours of the Tax Reform Conference Agreement
Congressional negotiators had a number of policy differences in the House and Senate bills to reconcile. While there was general agreement on lowering the individual and corporate tax rates, modifying individual tax brackets, and changing the treatment of pass-through income, there were a number of policy areas where the House and Senate differed. Nonetheless, the bill includes the final negotiated provisions, including:
- Individual Tax Rates. The final agreement temporarily adjusts the tax brackets, most notably lowering the top individual tax rate from 39.6 percent to 37 percent. The agreement follows the House bill and generally retains the present-law maximum rates on net capital gains. The brackets will be adjusted to inflation utilizing a Chained CPI index prospectively. The changes becomes effective 2018 and revert back to the current rates in 2026, unless Congress acts.
- Corporate Tax Rate. The agreement reduces the corporate tax rate to 21 percent beginning in 2018. The corporate tax rate in the final agreement is higher than the 20 percent rate that was proposed in the House and Senate tax bills.
- Treatment of Pass-Through Business Income. The bill will provide a 20 percent deduction for pass-through business income. The agreement is lower than the proposed 23 percent deduction that was proposed in the Senate bill and the 25 percent deduction that was included in the House bill.
- Alternative Minimum Tax (AMT). The final agreement repeals the AMT for corporations. It retains the AMT for individuals, but it also temporarily increases the exemption to $70,400 for individual taxpayers and $109,400 for couples beginning in 2018 and ending in 2026. The changes become effective in 2018.
- Estate Tax. The agreement maintains the estate tax but raises the threshold for an estate to qualify for the tax from $5.6 million to $11.2 million. The House proposed phasing out the estate tax. The compromise language aligns with the Senate proposal.
- State and Local Tax (SALT) Deduction. The final agreement caps the state and local tax deduction at $10,000 (property plus choice of income or sales taxes, as under current law), except for taxes paid or accrued in carrying on a trade or business. The agreement on the SALT deduction represents a compromise with the House bill, which included a full repeal of the deduction, while the Senate proposed to provide a $10,000 cap just on the deduction for property taxes.
- Medical Deductions. Congressional negotiators agreed to preserve the deduction for medical expenses and lower it to 7.5 percent of adjusted gross income (AGI) for two years. The agreement reflects the Senate language. The House proposed to eliminate the deduction.
- Private Activity Bonds. The final agreement retain the tax exempt interest status associated with private activity bonds (PABs) for infrastructure and certain other projects. The House-passed bill proposed to eliminate the deductibility of interest from such bonds.
- Charitable Tax Deduction Impact. The final tax agreement leaves intact the current charitable deduction but essentially doubles the standard deduction for individual tax filers, which will dramatically reduce the number of individual filers who itemize deductions on their tax returns. A reduction in the number of people who itemize is expected to reduce contributions made to charitable organizations as fewer people will look to take advantage of the charitable deduction.
The final tax agreement also includes key changes to the tax code as it relates to business expensing, multinational corporations, and healthcare-related taxes, including:
- Expensing. The final agreement permits full expensing of qualified property for five years, phased out for years six through ten. Section 179 features an expanded $1 million cap, with a phase out starting at $2.5 million. The language reflects a compromise between the House and Senate bills.
- Interest Deduction. The compromise bill retains the deduction for net interest business expense, but caps it at 30 percent of adjusted taxable income. Adjusted taxable income is the taxpayer’s taxable income disregarding any business interest expense or income, any net operating loss carryover, any new pass-through deduction for business income, and deduction for depreciation, amortization, or depletion (through 2021 only). The final agreement aligns with the Senate proposal.
- Net Operating Losses (NOL). The final agreement limits the NOL carryforward deduction to 80 percent of taxable income (determined without regard to the deduction), for losses arising in taxable years beginning after December 31, 2022. The limitation does not apply to a property and casualty insurance company. The provision generally aligns with the Senate bill.
- International Business Taxation. The final agreement shifts the US tax structure from a worldwide to a territorial tax system, while imposing a one time "deemed" repatriation on deferred offshore profits, with a differential rate of for liquid (15.5 percent) and illiquid (8 percent) assets. It also includes a base erosion and anti-abuse tax (BEAT) imposed at an increasing rate. The compromise language reflects a modified version of the Senate bill.
Health Care-Related Tax
- Orphan Drug. The final agreement maintains the tax credit for qualified clinical testing expenses incurred for the testing of rare diseases or conditions, but reduces the credit to 25 percent. The modification reflects the Senate proposal, which reduced the credit. The House bill eliminated the credit.
- Repeal ACA Individual Mandate. The tax agreement eliminates the Affordable Care Act requirement that an individual purchase healthcare insurance to avoid a tax penalty, as proposed by the Senate. The provision takes effect in 2019.
Former Congressman Phil English, Co-chair of the Arent Fox Government Relations group, and who served on the House Ways and Means Committee for 14 years notes:
“This tax legislation represents significant reform of the tax code, even if it is not as comprehensive as some initial blueprints proposed early in the process. This reform will improve the competitive position of the domestic economy, and provide a substantial boost to economic growth. New incentives for capital investment will improve the productivity of workers. Lower corporate rates, aligning US rates to the weighted average of EU countries, will reposition the American market to attract or retain critical investment. The tax initiative represents difficult compromises, and delivers moderate individual tax relief and simplification. Its success however will be judged by its ability to foster a moderate level of economic growth. This round of tax reform is almost certainly going to lead to more tax legislation, running the gamut from tax corrections to broad ideological initiatives spawned in the current polarized political environment. Ultimately most future changes are likely to affect rates, but leave the structural changes in place."
Former US Senator Byron Dorgan, now Senior Policy Advisor at Arent Fox, and who also served in the House of Representatives and was on the House Ways and Means Committee when it passed the 1986 Tax Reform Act notes:
“The expected final passage of the tax bill will be a victory for the Republican majority in Congress. The bill is not really a comprehensive ‘reform’ of the tax code. Rather it has been driven principally by a determination to reduce the corporate tax burden and it has done that successfully. The bill accomplishes that through the “expensing provision,” the reduction in the corporate tax rate, the elimination of the AMT (Alternative Minimum Tax), and other changes. The bill will also reduce individual income taxes to a lesser extent, with the major reductions benefiting the upper income individuals. The corporate tax cuts will be permanent and the individual tax cuts will expire in the future.
This legislation was put together quickly by the Republican majority. Given the scope of the bill and the complexity of the provisions, I believe there are some provisions that will be a compliance nightmare and will almost certainly lead to a “corrections” bill that will follow this legislation in the next year. The lower rate for pass-thru income and the arbitrary determination of who is eligible for that is just one of many examples of the controversy that will exist as the IRS attempts to define the provisions of the new legislation.
Another controversy that will attach to the bill is the increase in the federal debt used to provide the tax cuts. That contrasts with the last time tax reform was achieved when President Reagan, a supporter of tax reform, warned that he would veto the bill if it increased the deficit.”
Congressional Rules and Procedures Around Tax Legislation
We anticipate that the House and Senate will both consider the final version of the tax reform bill starting Tuesday, December 19, and that there will be sufficient Republican votes to assure the simple majority needed for House and Senate passage. This final version, known as the Conference Report, is not amendable, and thus the votes will be solely on final approval of the newly negotiated version unveiled on Friday evening. [Congressional Republicans used a legislative mechanism, known as budget reconciliation, to expedite the consideration of the tax bill in the Senate. Under the budget reconciliation structure, the tax bill will only require a simple majority of votes (51 votes) in the Senate to pass.]
Congressional Democrats remain unified in their opposition of the House and Senate tax reform bills and will continue to object as the final tax agreement advances through both chambers for a vote. No Democrats voted in favor of the House or Senate bills. House Speaker Paul Ryan (R-WI) will have a sufficient number of votes to pass the conference agreement on the tax bill along a party-line basis. While a few Republicans from coastal states – New York, New Jersey, and California – may vote against the bill due to the changes with SALT deduction, the defections are not expected to derail the outcome of the bill in the House. The vote will be closer in the Senate. Senators Bob Corker (R-TN) and Marco Rubio (R-FL) had considered opposing the legislation, but recently indicated they will support it. Given the slim Republican majority in the Senate, Senate Majority Leader Mitch McConnell (R-KY) cannot afford to lose more than two Republican votes on the final agreement to win passage in the Senate. Any defections from Senators could undermine or delay efforts to pass the bill in the Senate.
We would note, looking ahead, that the Budget Reconciliation instructions governing this legislation only allow Congress to increase the federal deficit up to $1.5 trillion over 10 years and that, due to a related Senate rule, unless Congress passes legislation in the years to come to provide funding to pay permanently for the tax provisions in the proposal, most of the policy changes will sunset in 2027.
Policy Implications Resulting from the Cost of the Both Tax Reform Bills
There is a great deal of speculation that Congressional Republicans will turn their attention in 2018 to aggressively reducing federal spending in non-defense areas to help offset the estimated 10-year, $1.5 trillion cost of the tax bill. House Speaker Ryan has recently stated that House Republicans will focus their efforts in 2018 on reforming healthcare entitlements to reduce the federal deficits. He also noted that, in addition to healthcare, House Republicans plan to work on reforming the welfare system.
There also are reports that White House officials have prepared an executive order that would set principles for a Congressional-led welfare reform initiative, as well as instruct federal agencies to enact new welfare regulations.
Sonja Nesbit, Senior Government Relations Director at Arent Fox notes:
“The passage of the tax reform bill will represent a huge victory for Congressional Republicans and the Trump Administration. The bill dramatically lowers the corporate tax rate and makes other changes that will be advantageous to businesses of all sizes. Nonetheless, as the legislation quickly advances in Congress, the $1.5 trillion cost of the bill, which is not paid for and will add to the federal debt, will have broad implications on decisions on federal spending in entitlement programs, including Medicare and Medicaid, in the future.
Congressional Republicans and the White House will turn their attention to efforts to dramatically reduce the federal debt immediately after the tax bill is signed into law. Any changes to Medicare reimbursement rates or efforts to reduce federal spending in the Medicaid program will have a negative impact on hospitals and other healthcare providers who depend on funding from these programs to provide healthcare services, conduct medical research and administer community-based programs.
The ripple effect of this tax bill will be large and will be felt for years to come.”
Arent Fox's Government Relations team will continue to monitor developments on the Congressional debate on tax reform. If you have any questions on tax policy, you can contact Byron Dorgan, Phil English, Sonja Nesbit, Dan Renberg, Jon Bouker, or the Arent Fox professional who regularly handles your matters.