Tax Reform Plan Forthcoming

After months of meetings, the so-called Big Six are preparing to release some sort of summary of their work the weekend of the 23rd.  The Ways & Means Republicans have a retreat that weekend, and Chairman Brady intends to use the time to sell the plan.  The idea is to get the Committee R’s comfortable, and then move on to the broader membership and the public.

What’s in the plan?  Recent conflicting accounts over rates suggests it’s still a moving target, but there are a few areas that seem firm.

For starters, we expect it will include a combination of specifics, options, and principles.  Where specifics are lacking, it could be due to ongoing disagreements, but it also could be out of a desire to give the committees some flexibility to craft their own plans within a certain framework.

Moreover, since the demise of the border adjustment and the $1 trillion in revenues it provided, the overall size of the package should significantly smaller, which means top tax rates will be higher than what was in the House Blueprint and many other beneficial provisions could be pared back or excluded entirely (such as the AMT repeal and full expensing).

We expect the health care tax provisions targeted for repeal in health reform to remain outside tax reform.  In other words, repeal of the device tax and investment surtax likely will have to wait for health care reform.  There should be lots of pressure on the tax writers to reconsider this approach, but we expect that’s where they will start.

Finally, paring back expensing coupled with higher tax rates on business income suggests the growth potential of the plan will be significantly smaller than the Blueprint, which means less positive economic feedback, which means less revenue from the new dynamic scoring.  It’s the opposite of a virtuous circle and in the end, key provisions in the Blueprint will have to be excised to make it all work.

Process:  The process from here resembles a game of Jenga, where everything is connected and one false move brings the whole effort crashing down.  That is because adoption of tax reform is contingent upon adoption of a budget resolution for FY 2018, but adoption of the budget resolution is contingent upon acceptance of the tax reform plan.

The latter is due to the fact that the House Freedom Caucus, representing a key voting bloc of about three dozen conservative (populist?) Republicans, has made clear they won’t support a budget until they are comfortable with the details of the tax plan it would enable.  As Politico points out, it’s putting the cart before the horse, but in practice it means that the tax writers will have to release the details of their plan before the budget resolution can move forward.

So that’s what they are going to do at the end of the month.  Will it work?  Here are some of the obstacles they will face:

House v. Senate:  While the Big Six includes both House and Senate negotiators, there is a strong chance the respective bills those bodies consider will be substantially different.  Differences between the two stopped them from releasing details just prior to the August recess, and those differences could signal fewer specifics this time around too.  In practice, both bodies will have to move their own bills anyway, so initial differences aren’t a deal killer.  But after all these months of negotiation, it does suggest getting the two bodies together on a final package won’t be easy.

Message Discipline:  The Administration continues to suffer from a remarkable lack of message discipline.  Over the last week, Treasury Secretary Mnuchin has talked about one tax reform plan, while the President has talked about a plan that sounds completely different.  How this resolves itself is anybody’s guess, but it does raise the possibility that the plan released by the Big Six at the end of the month may have one very prominent opponent.

Freedom Caucus Opposition:  The Freedom Caucus, or at least their leader, Congressman Mark Meadows, has put together a list of priorities that are difficult if not impossible to meet.  After leading the charge to kill the border adjustment and expensing, he has argued in recent weeks that tax reform should cut the corporate rate to 16 percent, among other things.  That’s well outside where Congress can go on tax rates, and begs the question of whether the Freedom Caucus will ever be satisfied with a plan that could actually pass?

Revenue Raisers:  To date, opposition has focused on big ticket items like the border adjustment and full expensing.  But the demise of the border adjustment puts increased pressure on tax writers to include lots of revenue raisers in the plan, and all those raisers have constituencies that will fight for them. Are the benefits of the plan compelling enough to overcome this opposition?  That’s a key question that will have to be answered.

So that’s the overview.  Tax reform is by no means a done deal and as the above list of concerns makes clear, there are lots of hurdles to overcome.  That said, the fact that Congress is preparing to transition from talking about tax reform to acting on it is a positive, and we look forward to seeing what they come up with.

Regarding S-Corp, we are focused on three things:  1) ensuring pass through businesses enjoy rate parity with C corporations; 2) making certain the international rules don’t penalize S corporations if the tax code transitions to territorial; and 3) making sure our modernization act is ready to be included in whatever tax bill is moving.

Expect to hear more from us on tax reform in the coming weeks.  It’s crunch time.

S-Corp Comments on 2704

Monday was the close of the comment period for Treasury Notice 2017-38, and the S Corporation Association joined several other trade groups in submitting our final comments on the pending Section 2704 rules, including our study highlighting the threat these rules pose to family businesses and their employees.
This comment period is the latest in a long saga and we hope it marks the beginning of the end.  To recap:
  • August, 2016 – Treasury issues Notice 2017-38 targeting proposed rules under Section 2704;
  • November, 2016 – The official comment period closes, with Treasury receiving a record number of comments in opposition to the rule (read S-Corp’s comments here);
  • December, 2016 – Treasury and the IRS host a hearing on the proposed rules, which lasts a record six hours (read S-Corp’s testimony here);
  • April, 2017 — Release of Trump Executive Order 13789directing Treasury to review all rules published since January 1, 2016 and identify those that are financially burdensome, unduly complex, or exceed Treasury’s authority; and
  • June, 2017 – Treasury targets eight rules for revision or repeal out of the 105 studied, including the harmful Section 2704 rules.
The study we submitted in this most recent comment period was authored by former Clinton economist Dr. Robert Shapiro makes clear that the Section 2704 rules violate all three of the criteria established in the President’s EO – they are financially burdensome, they are unduly complex, and they exceed Treasury’s authority.   They would also hurt the ability of these family businesses to grow and create jobs.  The study finds that:
  • Limiting valuation discounts under the Proposed Rule would increase estate taxes for large family businesses by $633.3 billion, in present discounted dollars, over the next 46 years.
  • To prepare for this additional burden, these businesses would divert resources, equivalent to the additional tax they will owe, from their normal business investments.
  • The projected reductions in their investments in equipment and machinery would reduce GDP growth, in 2016 dollars, by $2,476 billion from 2016 to 2062.
  • This slower growth also would reduce job creation over the next decade by 105,990 jobs.
The study was sponsored by the S Corporation Association and several other groups, including the Real Estate Roundtable, the Associated Builders and Contractors, and the Independent Community Bankers of America.
So now with numerous publications and comment periods behind us, the record is clear.  The proposed Section 2704 rules are harmful to family businesses and the people who work for them and need to be withdrawn.  Soon!  It has been just over a year since these rules were first published and it’s time to put them to rest.

S-Corp in the News

The Washington Examiner published a piece Monday on the implications the failed health care reform effort has for tax reform.  First among those is the continuation of the so-call Net Investment Tax that applies to investment and pass through business income.  As the Examiner notes:
And one of the taxes in particular, a tax on investments for high-income earners, hits many of the small businesses that Republicans have been trying to create new provisions to help. 
 
That would be the net investment income tax, a 3.8 percent tax surcharge on capital gains, interest and dividends for families making more than $250,000.  Repealing the tax would cut revenue by $172 billion over 10 years, according to Congress’ Joint Committee on Taxation. 
Although the tax applies to individuals, it also falls on businesses that file through the individual side of the code, a category that Republicans are hoping to privilege with a new special tax rate.
 
“It hits a broad swath of family businesses,” said Brian Reardon, President of the 
S Corporation Association. 
 
Nonmanagement partners in S Corporation businesses get hit with the 3.8 percent tax on the companies’ earnings, Reardon noted.  “It drains money from active businesses,” he said. 
 
S-Corp has been leading the charge to repeal this harmful tax since its inception seven years ago, most recently organizing a letter supporting the tax’s repeal signed by 40 national business trade groups.  The tax was initially presented during the Obamacare debate as a “Medicare” tax on high income investors, but it has nothing to do with Medicare and its burden falls on a large percentage of pass through businesses, as well as a majority of annual savings.  It’s a surtax on savings, pure and simple.
Failing to eliminate this tax as part of health care reform was a huge miss for the economy, so it must be done within the tax reform debate instead.  The business community is united around the idea of bringing down all business tax rates and moving towards rate parity, but that can’t happen with this tax in place.  It has to go.

Tax Reform Statement & Pass Through Taxes

Just in time for the August recess, the House, Senate and the White House released a joint statement yesterday on the status of their tax reform talks and their plans moving forward.  You can read the statement here.  From our perspective, here are the key points:
“While we have debated the pro-growth benefits of border adjustability, we appreciate that there are many unknowns associated with it and have decided to set this policy aside in order to advance tax reform.”
A primary purpose of the statement was to pivot the tax conversation away from the House Blueprint and the border adjustment tax (BAT).  The BAT was controversial from day one, but it also was proving to be an obstacle towards getting a budget resolution enacted in early September.  The leaders of the House Freedom Caucus had stated they would oppose the budget resolution without a promise that the BAT was off the table.  No budget resolution, no tax reform, so the BAT had to go.
Will it work?  Unclear.  Freedom Caucus Chair Mark Meadows (R-NC) was quoted this morning as saying that taking BAT off the table was nice, but they want clarity on the rest of the tax package before they would support the budget.  That sequence of details first, process second is the reverse of how congressional budgeting is supposed to work, and is an indication of just how difficult it will be to get the Freedom Caucus on board with any plan in September.
“The goal is a plan that reduces tax rates as much as possible, allows unprecedented capital expensing, places a priority on permanence, and creates a system that encourages American companies to bring back jobs and profits trapped overseas. And we are now confident that, without transitioning to a new domestic consumption-based tax system, there is a viable approach for ensuring a level playing field between American and foreign companies and workers, while protecting American jobs and the U.S. tax base.”   
The underlined lines, coupled with the demise of the BAT, indicate the negotiators are also moving away from full expensing and towards more limited capital cost recovery improvements, such as permanent bonus depreciation and faster depreciation schedules.  Full expensing was a predicate for the BAT and a cash-flow tax system, but it faced its own challenges.  It was expensive, it was paired with the controversial provision to disallow deductions of net interest, and it was received by the corporate community with a giant yawn.
“The goal is a plan that reduces tax rates as much as possible, allows unprecedented capital expensing, places a priority on permanence, and creates a system that encourages American companies to bring back jobs and profits trapped overseas.”
Temporary tax cuts are out and repatriation and territorial are in.  Both of these items are significant concessions by the Trump Administration, which had in the past made the case for temporary rate cuts and only lately embraced moving towards a territorial system.  The Blueprint relied on the BAT to enforce its territorial tax approach.  Now that it’s out, expect the tax writers to spend lots of time crafting more complicated “Camp Option C”-type rules to crack down on base erosion under a new territorial regime.
 “We also believe there should be a lower tax rate for small businesses so they can compete with larger ones, and lower rates for all American businesses so they can compete with foreign ones.”
This careful construction suggests that the tax negotiators have agreed to reduce rates for C corporations and pass through businesses alike (yea!) but have not settled on any other details, including whether the business provisions should be a tax cut or not.  Compare that language with the very specific “agreement that tax relief for American families should be at the heart of our plan.”  Meanwhile, White House advisor Steve Bannon has been busy selling a tax hike on high income earners.  As Bloomberg reports this morning:
“White House chief strategist Steve Bannon’s plan to raise the top income-tax rate for America’s highest earners could find some support among congressional Republicans as part of a populist message to sell a broader tax overhaul, according to one conservative lawmaker who has heard the proposal…. Automatic opposition isn’t a given among some GOP members, said the lawmaker who heard the proposal – especially if they’re made to understand how it could help publicly sell a plan that would include other changes to the tax code,” the lawmaker said.
These reports should act as a wake-up call for the Main Street community.  The Big Six (McConnell, Hatch, Ryan, Brady, Mnuchin, and Cohn) may have agreed that tax rates on all businesses should come down, but how that agreement squares with calls to raise rates on high income individuals, the majority of whom are business owners, is anybody’s guess.
So to sum up then, yesterday’s joint statement includes specific steps to advance the tax reform effort this fall.  Its call for ending the BAT and for considering tax reform under regular order are direct responses to criticisms that threatened to derail House consideration.  And the significance of all three actors – the House, Senate, and Administration – coming together to craft a joint statement should not be lost among the details either.  It is a commitment to get something done by the leaders of the government and should be taken seriously.
On the other hand, the brevity of the statement coupled with the Administration’s continued message muddle makes clear there’s lots of negotiating to come and many, many details to fill in.  As we have discussed in the past, those details are important – they could spell the difference between a tax package that treats Main Street fairly, and one that leaves it behind.  For that reason, we will be on the Hill pressing our case for fair treatment of all private businesses and the communities they serve.

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