House GOP tax reform proposal provides opportunities, challenges for business community
After months of anticipation, the Republican-led U.S. House of Representatives Ways and Means Committee finally released its tax-reform proposal last week. President Trump, House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell and Committee Chairman Kevin Brady have been promising the most comprehensive tax reform legislation since the Tax Reform Act of 1986. They did not disappoint.
There is much that members of the business community should love about proposal but also a host of things that they are not going to like. One of the biggest shocks to many pundits was that top earners making over $1 million individually (or $1.2 million jointly) would stay at an effective tax rate of 39.6 percent. This was a last-minute change Republicans made to win over additional support from Democrats on the committee. Whereas we are still a long way from the finish line, this last-minute change before the proposal’s release might suggest that there are other provisions which the Republicans will concede to secure a legislative win before the end of the year. Whatever the case, businesses and owners will need to start thinking about substantial changes to the way they finance, operate and conduct themselves.
The good news from the proposal is the reduction in the corporate tax rate. The rate for C corporations is proposed at 20 percent while pass-through entities such as LLCs, partnerships, and others are proposed at 25 percent. I personally have doubts that the C corporation rate will stay at 20 percent in the final bill, but it probably will remain much lower than the current rate. The justification for this new rate is based on international competition. Whereas the United States does not have the highest corporate tax rate, it is 16.4 percentage points higher than the worldwide average of 22.5 percent according to the Tax Foundation. Congress hopes that this new rate will encourage more investment in the U.S. and spur additional growth domestically.
The proposal also doubles the estate tax exemption to $11.2 million, which will benefit family business owners. This is one of the most popular provisions and one that Republicans have been fighting to pass for decades. Privately-held family businesses will benefit immensely from this change. Between 80 and 90 percent of businesses in the U.S. are privately held by families, and those companies generate more than 64 percent of GDP, making them extremely important to our economy. The doubling of the exemption will allow owners to pass more wealth to their heirs through the succession process when they are ready to retire.
However, there are some aspects the proposal that could hurt the business community. For example, limiting the deductibility of interest payments on corporate debt wasn’t a surprising move, but it could create challenges. There are a number of highly leveraged companies that could get hit hard by this move. The growing popularity of private-equity and debt financing to bolster businesses both large and small has helped to create some of the most successful companies in America during the past two decades. Those private-equity firms would be hit hard by this proposal, leading to fewer transactions which could negatively impact growth.
Additionally, the adjustments to the mortgage-interest deduction for individuals and families also could have an unintended ripple effect through the economy. Whereas only an estimated 9.3 million Americans have a second home, the number of families who own homes worth over $500,000 is substantial — especially on the Eastern and Western coasts. The home-building industry has only finally begun recovering during the past year as demand for housing has increased as the population increased. The home-building process involves numerous skilled professions including construction, maintenance, appliance manufacturing and many others. If the mortgage-interest deduction is reduced, buyers will be less likely to purchase a new home, which would impact these other sectors of the economy.
Arguably, the most important part of the House GOP proposal is the impact it could have on pass-through entities. As I mentioned earlier, the proposed tax rate for pass-through entities is 25 percent. However, that rate does not tell the whole story. The real winners here are passive investors who would get the 25 percent rate. Active owners such as partners and other professional service providers would be treated like corporate executives and still have to pay taxes at the 39.6 percent rate. To further complicate the matter, some active owners like retail-store owners, manufacturers and others would have 70 percent of their income taxed at the 39.6 percent rate, while only 30 percent of their income would be at the 25 percent rate.
Couple this complicated formula with changes to the alternative minimum tax and a host of business tax credits, and we begin to see a very burdensome weight placed on pass-through companies. It is very likely that a significant portion of pass-through companies would need to change their corporate structure in order to avoid paying much higher taxes. If passed in its current form, owners of pass-throughs will need to seriously consider what corporate structure will best suit the needs of their business.
In my 40-plus years as a certified public accountant, I have never seen a proposed tax bill make its way through Congress without substantial changes. The same will be true with this proposal. Whereas this bill is the most ambitious since the Tax Reform Act of 1986, there will be numerous concessions along the way that the business community will need to watch closely.
L. Michael Gracik Jr. is the managing partner of Glen Allen-based Keiter. His clients include closely-held businesses in the real estate, home-building, manufacturing, construction, retail and wholesale industries. He also serves many estates, trusts and foundations. Additionally, he has provided tax consulting and compliance services to the tax departments of publicly traded corporations.