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11/21/2017

House Passes Tax Cuts and Jobs Act and Senate Takes Center Stage in Tax Reform (article)


CBIZ helps you stay on top of tax reform.On a 227-205 vote, mostly along party lines, the House of Representatives passed its version of tax reform changes in the Tax Cuts and Jobs Act (the November 16 House Bill). The Joint Committee on Taxation estimates the tax reform bill will cost $1.4 trillion.

As with prior versions, the November 16 House Bill would reduce the corporate tax rate to 20 percent, eliminate the alternative minimum tax for individuals and corporations, eliminate many deductions and business credits, and trim the number of individual tax rate brackets to four. Most provisions in the House’s earlier draft legislation are retained in the final House Bill. These similarities mean that many of the same differences with the Senate Plan are retained, as highlighted in our previous coverage; however, there were a few changes in the final version of the House Bill that are noteworthy.

Notable Changes from Draft Tax Reform Plans

Of these, the most important is the introduction of a 9 percent rate for owners of pass-through entities. While the new 25 percent maximum rate would generally continue to apply, the 9 percent rate would aim to further benefit smaller business owners. The 9 percent rate would be applied to the first $75,000 ($37,500 for single individuals) of income from the pass-through entity, and would begin to be phased out for pass-through entity owners whose income from the pass-through entity exceeded $150,000 ($75,000 for single individuals). Hence, the 9 percent rate would apply in lieu of the 12 percent marginal tax rate that would otherwise apply at these levels. Furthermore, owners of service businesses organized by pass-through entities would also be eligible for the special 9 percent rate, subject to the income threshold, even though they would remain ineligible for the 25 percent rate. The 9 percent rate would be phased-in over time, and would not be fully implemented until 2022.

The November 16 House Bill retained changes proposed previously for cost recovery of research and experimental expenditures and for software development costs. Such costs would be required to be capitalized and amortized over a period of five years, as opposed to being eligible for immediate deduction under current law. The Senate Plan also is eyeing changes in this area, where it was recently updated to include a similar provision. Under both plans, the research and experimentation credit would be preserved.

Also included are provisions that aim to limit preferential tax treatment for carried interests that can be received by investment fund managers and certain real estate investors. These provisions were not included in the original House Bill, but were added among some of the first amendments to it. Individuals desiring the preferential tax treatment would be required under the November 16 House Bill to hold partnership interests that are treated as a carried interest for a three-year holding period before long-term capital gains tax rates could apply. The original Senate Plan also did not include proposed changes for carried interests, but like the House, the current Senate Plan has been updated to include similar provisions that require a three-year holding period. Under both plans however, the carried interest provisions are not expected to impact a majority of the taxpayers involved, where one research firm estimated that less than 25 percent of private equity deals that have occurred since 2000 would be impacted by the new three-year holding period.

The November 16 House Bill also removed a controversial provision contained in the earlier draft for deferred compensation arrangements that would have required income inclusion at the moment when a substantial risk of forfeiture is removed (which effectively would have eliminated the ability to implement a deferred compensation plan). Thus, the House Bill retains the current treatment of deferred compensation under Section 409A. The current Senate Plan also removed a similar provision, making the current law for deferred compensation applicable under both plans. However, the November 16 House Bill would remove the ability to make an election under Section 83(b) with respect to restricted stock units or stock options granted to employees, which would require such recipients to include the full value of such stock compensation in ordinary income at the time a risk of forfeiture lapses (i.e., when the stock compensation vests). To somewhat mitigate the tax consequences associated with this new rule, the November 16 House Bill would permit employees of nonpublic companies who received restricted stock units or stock options an election to spread income recognition over five tax years.

Also of note is that, unlike the November 16 House Bill, the current Senate Plan was recently changed to call for most of the beneficial changes for individual taxpayers to expire (sunset) after 2025. The House Bill would make its tax cuts for individuals permanent.

What’s Next for Tax Reform

With the House’s passage of this legislation, all eyes turn to the Senate. On the same day that the House Bill passed, the Senate Finance Committee passed its version of the Tax Cuts and Jobs Act on to the full Senate. This means that Senators will have the opportunity to debate their version and to offer amendments, which they are expected to begin after Thanksgiving.

By using budget reconciliation as the vehicle to transport their goal of tax reform, the leadership has avoided some of the procedural roadblocks that traditionally have been used to delay or block legislation. However, this same vehicle runs the risk of encountering political roadblocks that could be avoided outside of budget reconciliation.

In the Senate, budget reconciliation means that only 50 Senators (plus Vice President Pence) must vote for the measure for it to pass. Reconciliation also allows Senate leadership to shorten the time for debate. This means that there will be no epic multi-hour or multi-day filibuster events staged by Democrats in an effort to block the bill. But even with budget reconciliation rules, there is an open period under which unlimited amendments may be offered at the conclusion of this shortened debate period. These overtures can be used to slow the process, where each amendment proposal typically is debated for anywhere from 30 seconds to a few minutes, with a 10-minute vote to follow. Such amendments can also be used as a mechanism to force members of the Senate to cast politically unpopular votes. This so-called “vote-o-rama” can last for more than 10 hours.

The reconciliation rules also impose a requirement that the legislation not increase the deficit outside of a 10-year window. This limits the amount by which the Senate can cut taxes, and appears to be the primary force behind the provisions in the Senate plan that would sunset most of the individual tax cuts after 2025.

The 50-vote (plus Vice President Pence) threshold for Senate passage under the reconciliation rules is a double edged sword, as it makes each individual Republican Senator’s vote more important. As seen with the health care reform efforts, it only takes three Republican Senators to derail legislation, assuming no Democratic support is obtained. If the Senate is able to pass its version of legislation, the differences between it and the House Bill must then be addressed. It appears likely that a conference committee would be formed to do this, with Republicans from both chambers participating. The committee members would negotiate changes and would ultimately be expected to devise a compromise bill that could then be passed in each chamber. A compromise measure that subsequently passed both chambers would presumably be signed into law by President Trump.

Another consideration that might stand in the way of the President’s proposed Christmas deadline is that the tax reform packages (as currently proposed) would appear to trigger the PAYGO rules. The result would be that automatic spending cuts, including cuts to Medicare, the Border Patrol, and the National Flood Insurance programs could be imposed. These cuts would be politically unpopular, but as they fall outside of the reconciliation process, preventing them would require votes from Democrats.

Given that the differences between the two bills are significant and include potentially substantial sticking points, the compromise between the House and Senate visions for tax reform will require some give and take. The significant differences include a repeal the Affordable Care Act individual mandate (a provision currently in the Senate Plan, but not in the November 16 House Bill), the elimination of the state and local tax deduction, and how to reduce the tax rate on pass-through entities. Thus, the House passage of the Tax Cuts and Jobs Act clears one significant hurdle, but many more and potentially larger hurdles remain on the path to tax reform.

For more information on the November 16 House Bill or on the status of the tax reform process, please contact your local CBIZ MHM tax professional.

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