Yesterday (Wednesday, Dec 13) the Republican Congressional leadership reached an agreement on a “tax package.” Both the House and Senate will still need to have a final vote on legislation, but there is a great deal of optimism that Congress will soon present legislation to the President for signature, possibly as soon as next week. The final legislation reconciling the House and Senate tax reform bills has yet to be written and the time frame is very tight. The Senate plans to first take up a final bill, followed by the House – all which is set to begin next week. Based on media reports, below are highlights of the final package:
- 37% top tax rate for individuals (from 39.6%)
- 21% corporate tax rate, beginning in 2018
- 20% deduction for pass-through businesses
- Businesses would be permitted to immediately write-off investments, for the next 5 yrs
- AMT for individuals is retained, but exemption for couples raised to $1 million
- AMT for corporations is repealed
- Estate tax would be kept, although the exemption would be doubled
- The Affordable Care Act health insurance mandate repealed
- Mortgage interest on new mortgages up to $750,000, is permitted for write-off
In terms of the 20% deduction for pass-throughs, ABA’s tax consultants, Capitol Tax Partners (CTP), provided the summary below to explain how it will likely work:
Both the House and Senate tax reform bills cut the corporate tax rate in slightly different ways. CTP believes the final bill will cut the corporate tax rate to 21%, effective next year. Further, the House and the Senate bills provide tax relief to business income earned in “pass through” entities — sole proprietorships, partnerships and S corporations — to somewhat parallel the tax rate cut provided to corporations. But the House and Senate bills provide different types of pass-through relief. The House provides a maximum individual tax rate of 25% on qualified business income, with a smaller rate reduction for taxpayers whose business income did not exceed $75,000. The Senate bill provides a 23% deduction for qualified pass-through business income.
CTP believes the final reconciled bill will generally follow the Senate bill and provide a 20% deduction. Under this scenario, a pass-through entity would have qualified business income for this purpose. The amount of the deduction will be the least of:
(1) 20% of qualified business income,
(2) 20% of taxable income, or
(3) 50% of wages paid attributable to a qualified business.
The 50% wage limitation does not apply if the taxpayer’s taxable income is less than $250,000 ($500,000 for married taxpayers filing jointly).
So, if a taxpayer is earning $100,000 today in salary at their business, and the company earns a $100,000 profit that is currently passed through to them today, the taxpayer likely will be able to reduce their taxable income by $20,000 ($100,000 of qualified business income from the S corporation x 20%). The wage limitation would not appear to apply, and even if it did, the S corporation has at least $100,000 of wages and the limitation would be no less than $50,000 ($100,000 x 50%). Finally, the taxable income limitation would not apply because the taxpayer appears to have in excess of $100,000 of taxable income ($100,000 business profit + $100,000 salary less undisclosed deductions).
The value of this $20,000 deduction will depend on the marginal tax bracket of the taxpayer in the example. Under the House rate structure, they would be in the 25% bracket, saving them $5,000 in taxes. Under the Senate rate structure, they would be in the 24% bracket, saving them $4,800 in taxes. This would be in addition to any other savings under the bill that are applicable to all taxpayers.
To get some sense of the interplay between tax rate cuts and the 20% deduction, assume the taxpayer in this example is married and has $200,000 of taxable income. Under present law, they would pay $42,885 of Federal income tax. Assuming the 20% deduction and the Senate rate structure (and no other effects of legislative changes), they would pay $32,274, about half of their tax savings coming from the 20% pass through deduction and half coming from the overall rate cuts. Naturally, there are other things in the bill that may increase or negate some of these savings.
The remainder of this week and next week will be critical to watch, as the Republicans push through the final stages of securing tax reform to stave off charges of a “do-nothing Congress,” with 2018 mid-term elections looming and a spate of unexpected retirements. ABA will continue to publish updates as appropriate.