In many long term complicated ventures there is that time, call it a tipping point, when what seemed unlikely now looks quite certain. The actions of the U.S. Senate in the overnight hours this past Friday leading into Saturday, have that feel. The full Senate passed a tax reform bill on almost strict party lines, 51-49, with only one Republican casting a no vote. Given the results of their earlier effort to revise our national health care laws (the Affordable Care Act from the Obama years), no one was going to assume they would get this done. But they did.
So now there is really one more process to occur, that being negotiations between the House and Senate on their respective versions of the law, before our federal tax laws experience the most sweeping changes since 1986. The negotiations are known as a Conference Committee, with selected members of the House and the Sentate hammering out their differences. Unless the House accepts the Senate version as written, which is highly unlikely, there will be revisions that require both sides to take the final agreed package back to their membership for what they hope would be a majority approval vote.
There seems to be no deterrence from the Republicans pushing to have the entire effort concluded before the end of December. So during December, what are we watching in particular in these negotiations? The change to the estate and gift tax laws is simple, yet massive. Both sides seem set on doubling the current exemption from tax from $5.6 million to $11.2 million, with continued adjustments for inflation. While for complicated budget reasons the change in the exemption would expire in eight years, that leaves more than ample time for our clients to engage in thoughtful and effective planning in how to best make use of that increased ability to transfer wealth. Both sides have essentially the same provision, so we anticipate it will be included in the final negotiated package.
Another item of special note is the change coming to the taxation of business income. This will be as well a massive change to current law, however it will be anything but simple. The House and the Senate have very different approaches to the taxation of business income, so it is hard to tell how this will play out. Bets will probably be on the Senate approach prevailing, given the extremely slim margin that the Senate managed to pass its bill, and that three Senators conditioned their yes votes to the details described below that were included in the bill Friday night.
What is the Senate approach? Boiled down, it would provide for a deduction equal to 23% of your business income from non-C corporation sources (partnerships, LLCs, S corporations, sole proprietorships). As a simple example, assuming you are in the highest income tax bracket (e.g. 38.5% under the new Senate bill), your flow-through business income on your tax return would have an effective tax rate after the deduction of just under 30%. Is this good or bad? Well, it is better than the income being taxed at full ordinary income rates as in current law. However, it is higher than the new C corporation rate of 20%, although below the C corporation tax hit that occurs after the C corporation distributes nondeductible dividends.
A moment is needed to describe what we mean by "business income". It is not only referring to actively owning and running your own business and receiving your share of the profits. Under the Senate approach it will include your share of income from any investment in a pass-through entity, regardless of your participation, if that entity is engaged in a qualified trade or business (note, only U.S. based income, and many professional service businesses will not qualify). So, think private equity and other forms of investment in the non-public markets. You can be a passive investor and will receive the business tax rate on your share of the flow-through income.
Assuming something like the Senate bill is passed, we are headed for the tax laws having the following tax rates on high income taxpayers for various common types of income, and you can see what income our tax policy has favored:
When all is said and done, the two biggest income tax changes we could see are that C corporation income will be taxed at 20% instead of the current 35%, and business income of individuals will be taxed at a maximum 29.6% rather than the highest brackets under current law. Needless to say, differences in tax rates will play into the investment decisions we review with you when looking at publicly traded stocks, corporate bonds, municipal bonds, real estate, private equity, and direct investments in private business ventures.
There is so much more to share, but we now have to see what makes the cut out of the Conference Committee. Stay tuned this month.