By Joe Poore, CPA, senior manager, Elliott Davis
Even on the campaign trail, then-candidate Donald J. Trump was clear about his views on tax reform. He wanted a “yuge” tax cut. After a surprisingly strong electoral victory, Republicans seemed to have all the pieces in place to deliver: political momentum, majorities in both the U.S. House and U.S. Senate, and a president eager to achieve a legislative success.
Over the past several weeks, Republicans in the House and Senate have finally released tax reform bills. As stump speeches have been distilled into actual legislation, it is has become clear why the country has not had major tax reform in three decades. Successfully passing major tax reform is the equivalent of finishing a triathlon.
The Republican political strategy for passing tax reform relies on a unique Senate rule called reconciliation. Using reconciliation as a legislative tactic allows the Senate majority to avoid filibusters from the minority party and pass legislation with only 51 votes. The tradeoff is that special rules apply to bills approved through the reconciliation process. The rules narrow legislative flexibility by imposing strict financial contours on proposed legislation. In the case of tax reform, the rules require that tax reform legislation cannot increase the deficit by more than $1.5 trillion dollars over the next decade. When it comes to tax cuts, every taxpayer is fighting for the same pot of money.
The centerpiece of the tax reform plan is a reduction in the corporate tax rate from 35 percent to 20 percent. According to the U.S. House Committee on Ways and Means, the corporate tax rate reduction will cost $1.46 trillion over the next 10 years. This break leaves very little room for additional cuts without surpassing the cap of $1.5 trillion imposed under the reconciliation rules. While corporate taxpayers receive a large tax break, other taxpayers may see relatively small benefits or no benefit at all.
One group hoping for a larger piece of the tax cut pie is small-business owners. Many small businesses are structured in various legal forms commonly called “pass-through” entities. Pass-through businesses comprise the majority of U.S. businesses. According to the Brookings Institution, over 90 percent of pass-through businesses have $10 million or less in annual sales. Hence, the colloquial name “small business.” Small businesses also earn the majority of business income in the United States and employ the majority of the private-sector workforce. In short, these are the types of businesses that line Main Street USA and form the backbone of the U.S. economy.
Pass-through businesses, which include sole proprietorships, partnerships, S-corporations, and LLCs taxed as partnerships or S-corporations, generally do not pay tax. Instead, the businesses “pass-through” profits to the owners who pay the tax on income from the business. Under the Republican House plan, income for these small businesses would be taxed at a special 25 percent rate. However, special rules in the House plan could substantially limit the amount of business income taxed at the lower 25 percent rate. Business income not taxed at this preferred rate would be subject to individual income tax rates, which could be much higher.
The Senate plan maintains the corporate tax cut but offers a different plan for non-corporate small businesses with a special 17.4 percent deduction on pass-through income. Although some key provisions are similar in the House and Senate plans, they contain important differences on other popular tax benefits, such as the deduction individual taxpayers can claim for mortgage interest, state income taxes, sales taxes, and property taxes. The Senate plan also preserves the politically divisive estate tax.
While House and Senate leaders attempt to find a narrow path to legislative victory, taxpayers wait and wonder if some of the tax cut benefits will ultimately trickle down to their pockets or if someone else will get the majority of the limited tax cut benefits available.
Due to the dynamic nature of the legislative process, the legislative provisions within tax reform are subject to daily change. This article is based on legislative proposals in place prior to press time. At elliottdavis.com, you can find up-to-date summaries of current legislative proposals. Contact the author at [email protected].