July 24, 2017 - Weekly Legislative Update
Obama Care Defeat Complicates Tax Reform
The demise of Obama Care repeal in the Senate, which the President is urgently struggling to revive, will complicate tax reform because Obama Care taxes will remain in effect.
Obama Care repeal and replace bill, American Health Care Act of 2017, HR 1628, that passed the House on May 4 eliminated the taxes that provide revenue to fund premium tax credits and subsidies. For HR 1628 the Joint Committee on Taxation estimated total revenue loss from repeal of Obama Care taxes to be $423.2 billion over the ten year period, FY 2017-26 (www.jct.gov, see JCX 12-17 and JCX -16-17).
These taxes are primarily a 0.9 percent surtax on the incomes of wealthy individuals, 3.8 percent surtax on net investment income, and the medical device tax.
If not repealed, these taxes remain in the budget as revenue streams to the government-in that way, they become part of the revenue baseline for tax reform. When tax reform comes up, the question of what to do about these taxes cannot be avoided as there will be pressure to repeal them and fund the exchanges out of general revenues.
For instance, assume that all taxes in the Affordable Care Act are repealed. The tax reform score card, which calls for tax reform to be revenue-neutral, will score this $423 billion on the "revenue lost" side of the ledger, along with revenue lost from reducing corporate and individual tax rates. This revenue lost must be made up on the other side of the ledger.
This it's necessary to come up with a $423 billion revenue offset, increasing the pressure to cut tax credits and deductions. If Obama Care repeal and replace had passed the Senate, this $423 billion wouldn't be in the budget baseline and producing a revenue-neutral tax reform bill would be that much easier.
We don't know what Speaker Ryan will do with the Obama Care taxes when tax reform comes up; because he's eager to get the corporate rate down to 20 percent, he may let them stand. His plan as it stands isn't revenue-neutral unless he falls back to the 25 percent range or gets a border tax or some other revenue stream, so why add $423 billion to the hole he must fill?
Obama Care taxes are a complication we'll have to watch and factor into our lobbying for permanent WOTC. Now, let's turn to the Budget Resolution.
The Budget Resolution For FY 2018 being marked up in the House Budget Committee carries two important requirements: first, the tax reform bill must be revenue-neutral over the ten-year budget window; and second, mandatory cuts in tax credits and deductions shall be used to offset the revenue loss from lower overall tax rates.
It's recognized that killing tax credits and deductions isn't enough to fund a corporate rate of 20 percent; Ryan tried and came up $1 trillion short, making up the difference via border adjustment tax. Treasury Secretary Mnuchin has tried, admitting he's $2 trillion short even after "cutting everything in sight." Twenty percent is a tough target, Mnuchin is relying on the boost in economic activity from tax cuts to fill the gap.
Ryan, McConnell, Mnuchin, and Cohn are still meeting to negotiate a single tax reform "framework." The three frameworks in contention are Ryan/Brady, McConnell/Hatch, and Mnuchin's-Ryan spelled out in detail, Hatch in sections, and Mnuchin's a one-pager. The Ryan-Brady bill has already been drafted but locked in a safe-it's debut postponed by the White House insisting on writing its own bill.
The Ryan-Brady detailed plan was published online last October in the GOP election manifesto, "A Better Way." This important document is still relevant and available at www.better.gop, click on "tax reform."
On July 19, the House Budget Committee introduced the Concurrent Resolution on the Budget for FY 2018 including reconciliation instructions for a revenue-neutral tax reform bill. This is the first step in launching a bill that, under the Budget Act, can't be filibustered and can pass by simple majority.
New budget authority for discretionary programs is divided $622 billion for defense and $511 billion for civilian agencies. To this add $2.4 trillion for entitlements to get total FY 2018 budget of $3.5 trillion.
The Budget balances in ten years, FY 2017-2026, via claimed $6.5 trillion in deficit reduction. Actual reductions mandated in the Resolution are $2.7 trillion, with another $1.5 trillion attributed to macro-economic effects, total $4.2 trillion. We must assume the remaining $2.2 trillion are cuts embedded in the budget ceilings given in the Appendix tables.
The largest mandated savings (reduction) of $57 billion over ten years is directed toward Ways and Means which has jurisdiction over Social Security, Medicare, Medicaid, and Welfare, where it must find the savings.
The second largest cut of $20 billion is directed to the Education and Workforce Committee which funds Workforce Investment Act training programs. Most of these funds are distributed to the States, so states will be impacted along with national programs.
We could face a reduction in the $18.5 million yearly allowed for WOTC program administration and will have to fight for it in the Appropriations Committees as we do every year.
Push Toward Tax Reform
On July 17, 2017, TIA and the Small Business Legislative Council (SBLC) sent comments to members of the Senate Committee on Finance, as the committee prepares for the upcoming push towards tax reform.
While TIA strongly supports efforts to make the tax system simpler and more manageable, it is critical that tax reform not come at the expense of small businesses and their employees. Already, in the House Blueprint and the President's outline, there have been proposals that are deeply concerning for small business and could undermine small business' role as a critical driver of growth and job creation in this country. As discussed further below, TIA urges the Committee to reject these problematic ideas and use tax reform as a vehicle to help, rather than hinder, small businesses.
Tax Rates for Pass-Through Entities
Greater parity is needed between the tax rates for pass-through entities and C corporations. However, if a new system is created for taxing pass-through entities, the applicable rules should be clearly outlined in the legislation itself and should be structured to ensure that they do not have the unintended effect of disrupting the small business retirement plan system.
Under the current tax laws, pass-through businesses, which constitute the large majority of business enterprises and employ over half of the employees in the United States,1 are at a disadvantage when compared to publicly and privately held C corporations. Unlike pass-through entities, regular C corporations separately report their taxable income and pay income tax on that taxable income. Under current law, the top marginal rate for C corporations is 35%, whereas the top marginal rate for income earned through S corporations, partnerships and sole proprietorships is 39.6% (passive investors are also subject to an additional 3.8% net investment tax). This gap needs to be narrowed or eliminated. If the C corporation rate is going to be reduced through tax reform, the rate for income from pass-through entities must be as well.
Both the President's outline and the House's Blueprint include proposals to reduce the tax rate for pass-through entities by creating a distinction between "active business income" and "reasonable compensation for services." This proposal would require owners of pass-through entities to take "reasonable" compensation for their services, which would be taxed at their personal income tax rate, and then allow them to receive other business income subject to a much lower tax rate. Provided that the reservations discussed below are adequately addressed, the TIA strongly supports this concept.
First and foremost, if a new structure, like the one noted above, is going to be introduced for taxing pass-through entities, it is essential that the rules for its application be clear and outlined in the legislation itself. While the concept of distinguishing between "active business income" and "reasonable compensation for services" sounds relatively simple, the rules for determining what constitutes reasonable compensation for services have the potential to become very complex. Small businesses do not have the same financial or administrative capacity to navigate complicated rules that their larger counterparts do. It is therefore critically important that the rules be clear and easily understood and applied. To ensure that this is the case, it is important that Congress clearly articulate the framework in the law itself rather than delegating the power to the IRS to do so. Even if the current Administration has given assurances that new tax regulations will not be overly complex, delegating authority to the agencies to add detail to a tax reform law leaves open the possibility (and we would argue makes it likely) that, over time, the law's goal of simplification will be lost amidst increasingly complex regulations.
Another consideration that TIA urges the Committee to address in considering a new tax system for pass-through entities, is the implications that a reduced tax rate for business profits could have on the small business retirement plan system. Most small business owners view the administrative costs associated with maintaining a plan and the meaningful contributions that they make for non-key employees as the price of being able to save in a qualified retirement plan for themselves. If the small business owner has the opportunity to take profits out at a rate that is significantly lower than his or her individual tax rate that would apply to retirement funds at the time they are withdrawn, the small business owner is going to take the money out of the business at the reduced rate and invest it elsewhere. In turn, if the small business owner has no financial motivation to save in a retirement plan, the small business is much less likely to create a new plan or continue to offer an existing plan. This would be a significant blow to employees and be counter to the goal of encouraging increased retirement savings. To avoid this problem, if a small business owner is going to be required to take a certain amount from the business as "reasonable compensation for services" before the reduced tax rate will apply, it is important that the contributions towards the retirement plan count towards reasonable compensation for services. Logically, this makes sense as the idea behind the distinction is to ensure that a certain amount of the business' income is being taxed at the business owner's standard individual rate and anything that is saved in a retirement plan will be subject to the individual rate when it is withdrawn. Additionally, it will continue to motivate small business owners to sponsor retirement plans that will allow them, and their employees, to save for the future.
Business Interest Deduction
Small businesses rely on debt financing not equity to establish themselves and survive. The elimination of the business interest deduction would therefore be severely damaging to small business growth and success.
Both the President's outline and the House Blueprint have proposed to eliminate the business interest deduction. This proposal in the House Blueprint seems to be linked with a proposal to allow full and immediate expensing. TIA does not believe there is any reason for these two proposals to be linked together. While TIA supports immediate expensing, eliminating the business interest deduction would result in dramatic loss of financing options for small businesses, making it much more difficult for new businesses to start and existing businesses to thrive.
Small businesses rely heavily on traditional debt financing. Unlike equity financing, debt financing allows small business owners to maintain their ownership of, and control over, their businesses. Moreover, many alternative or creative funding options aren't available to small businesses, particularly in their early years. Eliminating the business interest deduction would result in a double tax on the interest itself. Without the business interest deduction, before being paid as interest, the amount would be taxable to the business, but then would still be taxed as income to the lender. As the result of this treatment, and the increased costs and decreased gains that it will cause, those lenders that traditionally service small business clients, like community banks, are likely to reduce their borrowing options. This will make it more difficult for small businesses to get the debt financing they need and will strike a significant blow to the small business economy on which a huge part of the national economic stability depends.
The Estate Tax and the Step-Up in Basis
TIA is in favor of repealing the estate tax but only if the step-up in basis at death is maintained.
Although many small businesses fall below the current estate tax exemptions, some small business owners still find themselves subject to the estate tax. TIA supports a repeal of the estate tax to encourage these small businesses to grow and survive across generations. While some small businesses would be favorably impacted by estate tax repeal, far more small businesses would be negatively impacted, catastrophically, by a repeal of the step-up in basis at death.
Under the current law, family members who inherit a business take the business at its value as of the date of the original owner's death. However, if the step-up in basis were eliminated, the family members would be required to pay capital gains taxes on the original owners' gains in the business. In short, rather than bequeathing his or her descendants a legacy, a successful small business owner who grew his or her business from scratch, would be bequeathing his or her descendants a large tax burden, which many families may be unable to pay without selling the business.
There is absolutely no reason for the repeal of the estate tax and the repeal of the step-up in basis to go hand in hand. However, in the past, there have been too many proposals to repeal the estate tax that are either silent on the step-up in basis or seek to use the repeal of the step-up in basis as a leveraged trade-off for the elimination of the estate tax. TIA urges the Committee to reject any proposal to eliminate the step-up in basis as doing so would be extremely detrimental to a large number of America's small businesses.
To promote simplification in the tax code, the AMT should be eliminated.
The AMT is the epitome of our overly complex tax code because it essentially requires taxpayers to calculate their taxes twice. Particularly for middle and upper middle income taxpayers, which many small business owners are, this means that they have to expend precious funds on engaging a professional to help them make the calculations. To achieve greater simplicity in the tax code, and relieve this undue burden on the taxpayers, the TIA urges Congress to eliminate the AMT.
Health Insurance Premium Deduction/Exclusion
The current system which allows employers to deduct health insurance premiums and employees to exclude health insurance premiums from their income, has the very positive effect of encouraging employers to contribute towards health insurance premiums, and should be maintained.
Under the current system, an employer contribution towards an employee's health insurance premium provides a win for both the employer and the employee. The contribution helps the employee get health insurance without it being included in the employee's income. In turn, the employer gets to deduct the contribution, so, although it is providing a huge benefit to its employees, it is able to do so at a relatively low cost to itself.
If the tax laws are changed in a way that would eliminate or reduce the benefit that employers get from contributing towards employee health insurance or reduce the benefit of these contributions to employees by making them taxable, it would cause many small business employers to give second thought to making such contributions. Employer contributions towards health insurance premiums are critical to helping many Americans afford health insurance and any change that would deter employers from making these contributions would be a move in the wrong direction.
The Small Business Retirement Plan System
The qualified retirement plan system, has been very successful in providing retirement security for a significant number of Americans. It is important that those provisions that have encouraged plan sponsorship among small businesses and saving by small business employees are not negatively impacted by tax reform.
Most small business owners are motivated to establish plans, and to make contributions for their employees, by a desire to save for their own retirement. If the tax laws are changed to reduce the ability or appeal of saving in a retirement plan, small business owners will be much less likely to continue an existing plan or start a new plan.
Accordingly, so as not to disturb the current successful small business retirement system, TIA urges Congress to:
- Reject attempts to decrease the amount that can be saved in a qualified plan. If the amount that small business owners can save in a qualified plan is reduced, small business owners will be motivated to freeze or terminate plans once they themselves have hit that cap. This will mean that fewer small business employees will be offered a plan.
- Avoid changes that would quickly force savings out of a plan after the owner's death or otherwise do anything to make owners concerned about saving too much in a retirement plan. If small business owners are concerned that their descendants who inherit their plans assets will be forced to take the money out over a short period of time and therefore face negative tax consequences, the owners are likely to save less in the plan, which will not only impact their retirement security but that of the other employees of the business as well.
- Protect the deductibility of employer contributions. If the deduction for the employer contribution is eliminated, employers will be far less likely to contribute towards an employee's retirement savings.
- Reject proposals to try to limit how much can be saved in a defined contribution plan pre-tax, (i.e. to force some or all of the defined contribution retirement plan system towards Roths). If employees are taxed on contributions to a plan, they will be less likely to save, which, given that people are far more likely to save in employer-sponsored retirement plans than in any other vehicle, would reduce retirement savings overall.