Senate Releases Its Tax Bill: Current Law vs House Tax Proposal

Senate Releases Its Tax Bill: Current Law vs House Tax Proposal

Then, late last night, just as the House Ways and Means Committee culminated a four-day mark-up of HR 1 by voting to advance the bill along party lines, the Senate decided it was time to get in the mix by releasingits plan to revise the tax law.

There’s a lot to take in, clearly. It was hard enough to fully grasp how current law compared to the House bill, but now we’ve got to layer on the Senate proposal, which varies from both current policy and the House proposal in several significant ways.

What follows is a summary of the opening week of “tax reform season,’ with an item-by-item comparison of current law, the updated House proposal, and the newly-published Senate bill.

Individual Tax Rates

Current Law

Ordinary income — items like salaries, interest income, and business income — is subject to a seven-bracket progressive system. Those rates are 10%, 15%, 25%, 28%, 33%, 35% and a top rate of 39.6%.

HR 1 proposed four brackets: 12%, 25%, 35% and 39.6%. Taxpayers earning more than $1 million (if single, $1.2 million if married) would also be required to “clawback” the benefit of the 12% bracket at a 39.6% rate, increasing their tax by the excess of the 39.6% rate over the 12% rate on the first $45,000 of income (if single) or $90,000 (if married). This amounts to an increase in tax of $12,420 for single taxpayers and $24,840 for married, and an effective top marginal rate of 45.6%.

Senate Bill

The Senate bill retains a seven-bracket systems, but lowers the rates to 10%, 12%, 22.5%, 25%, 32.5%, 35%, and a top rate of 38.5%.

Here is a comparison of thee three possibilities, first, for single taxpayers:

And here are the rates for married taxpayers:

Observation:

Take note that relative to the House bill, the Senate proposal would force some lower-income ($38,700 – $45,000) and middle-income ($170,000-$200,000) taxpayers into higher marginal rates (12% versus 22.5% and 25% versus 32.5%, respectively). The same is true for married taxpayers on the low-income side, where those earning between $77,400 and $90,000 would pay a top rate of 12% under the House bill but 22.5% under the Senate proposal.

It’s also worth noting that the Senate plan preserves the marriage penalty that exists under current law, at least for middle-income taxpayers. For example, the 32.5% rate starts at $170,000 of income for single taxpayers, but at $290,000for their married brethren. A smaller penalty exists at the start of the 35% bracket ($200,000 versus $390,000), but just as we saw with the House plan, NO penalty exists for the richest taxpayers, as the top 38.5% bracket starts at $500,000 if single, and $1 million if married.

Like the House bill, the Senate proposal would adjust the brackets for inflation using chained CPI, rather than the standard CPI used under current law. This will cause taxpayers to accelerate through the brackets more quickly than under current law, likely leading to higher tax liabilities in later years of the ten-year budget window.

Capital Gain/Dividend Rates

Current Law

Under current law, those in the 10% and 15% brackets generally pay a 0% tax on gain from the sale of capital assets (things like corporate stock or your home) held longer than one year and qualified dividends. Above those income limits, taxpayers pay at a 15% rate until income reaches the start of the 39.6% bracket. For those in that top bracket, the rate on capital gains and dividends is 20%.

House Bill

HR 1 preserves the 0%, 15% and 20% brackets, and aligns those rates with the new brackets.

Senate Bill

The Senate proposal also preserves the same rates as under current law, and aligns those rates with the current law brackets, resulting in no change for taxpayers relative to current law.

First, single taxpayers:

Then, married:

Observation

It’s worth noting that the 3.8% net investment income tax that was added to the law as part of Obamacare remains in place. Thus, the top rate on long-term capital gains and dividends is more accurately represented as 23.8%.

Standard Deduction

Current Law

All taxpayers are entitled to deduct the greater of 1. the “standard deduction,” or 2. the sum of itemized deductions, described below. Under current law, the standard deduction is $6,350 for single taxpayers and $12,700 for married taxpayers.

House Bill

HR 1 increases the standard deduction to $12,000 (if single, $24,000 if married).

Senate Bill

The Senate bill also doubles the standard deduction to $12,000 (if single, $24,000 if married).

By nearly doubling the standard deduction — while at the same time eliminating many itemized deductions — should the House or Senate bill become law, nearly 90% of taxpayers will claim the standard rather than itemize. This adds much needed simplicity for both taxpayers and preparers.

Personal Exemptions

Current Law

Each taxpayer is entitled to a $4,050 deduction for oneself, one’s spouse, and any dependents.

House Bill

Personal exemptions would be eliminated. To soften the blow a bit, however, the Child Tax Credit will be increased from $1,000 to $1,600, though the refundable amount will not rise. In addition, a new $300 credit will be allowable for non-child dependents, and for the next five years, a “family flexibility” credit of $300 will be allowed for each spouse. In addition, the income limits at which a taxpayer starts to lose the child tax credit will be increased from $75,000 to $115,000 for single taxpayers and $110,000 to $230,000 for married taxpayers.

Senate Bill

The Senate bill would also eliminate personal exemptions. As was the case with HR 1, the Senate bill will attempt to ease the pain on families by increasing the Child Tax Credit to $1,650, a $50 increase over the House proposal but a $650 rise when compared to current law. The Senate proposal provides protection for the upper reaches of the middle class that is missing from the House bill, however, by increasing the income levels at which phase-out of the credit begins to $500,000 (if single, $1,000,000 if married). This will enable many more taxpayers to make up for lost personal exemptions with the enhanced CTC as compared to HR 1.

That’s the good news; the bad news, however, is that unlike the House bill, the Senate does not offer any additional credit for a taxpayer, his or her spouse, and any non-dependent children. To illustrate, a married couple earning $100,000 and claiming three dependents (two children and one elderly parent), would be entitled to the following credits under the House and Senate bills:

Observation

The table above will begin to equalize in 2023, when the $300 credit available under the House bill disappears. But until that time, families will be disadvantaged under the Senate proposal, as it is unlikely the small change in tax rates will make up for the loss of the $4,050 personal exemption.

In addition, because the Senate bill does not increase the refundable portion of the Child Tax Credit, but DOES substantially increase the income phase-out thresholds, a family of four with taxable income of $200,000 will enjoy a greater reduction in tax than a family of four with income of $30,000.

Itemized Deductions

Current Law

As stated above, each taxpayer is entitled to deduct the greater of: 1. a “standard deduction,” or 2. the sum of itemized deductions.Itemized deductions include popular tax breaks such as the deductions for:

• medical expenses
• mortgage interest expense (on up to the first $1.1 million of acquisition and home equity debt)
• personal casualty losses
• real estate taxes
• state and local income taxes
• charitable contributions
• unreimbursed employee expenses
• tax preparation fees

The House and Senate Bills

Perhaps its best to compare the House and Senate bills treatment of itemized deductions in table form:

Observation

I give credit to both the House and Senate for taking a hard line in eliminating the deduction for state and local income taxes; it will be hugely unpopular in high-tax states like New York, New Jersey and California, but it’s a necessary evil if either bill is going to hit its $1.5 trillion target of net tax cuts. In all likelihood, this will serve as the biggest point of contention in the Senate — as several GOP leaders from the aforementioned high-tax states have already called the provision a nonstarter — and it will be fascinating to see who backs down first.

The Senate bill is unlikely to curry any more favor with the real estate lobby than the House bill has, as it completely eliminates the deduction for real estate taxes while also limiting the mortgage interest deduction (although to a significantly smaller degree than the House bill). Add in the fact that both the House and Senate bills make it more difficult to sell your primary residence tax-free (by lengthening the ownership and use requirements of Section 121 — which allows for an exclusion from gain of up to $250,000 (if single, $500,000 if married) — from two out of five years to five out of eight years, and it makes for a nation full of unhappy realtors.

Other Popular Deductions

Current Law

In addition to itemized deductions, certain expenses are allowable on page 1 of an individual’s tax return. These types of deductions are advantageous because a taxpayer will benefit from these expenses regardless of whether they itemize or claim the standard deduction. Included among these deductions are alimony payments, student loan interest, moving expenses, and a $250 deduction for teachers who purchase school supplies.

The House and Senate Bills

Again, let’s look at this in table form:

Pass-Through Business Income Tax Rates

Current Law

Taxpayers may operate a business in their individual capacity — as a sole proprietorship — or through a partnership or S corporation. The latter two business types do not pay tax at the business level; rather, the income of the business is allocated among the owners, who pay the corresponding tax on their individual returns. As a result, the individual owners are at the mercy of their respective individual rates, which as stated above, rise as high as 39.6%.

House Bill

HR 1 would apply a top rate of 25% on the income of S corporation shareholders, partners in partnerships, and sole proprietors. There are a number of caveats, however:

1. Only passive investors in a business are entitled to the 25% rate on all of their income from the business.
2. For any investor who “materially participates,” the default setting is that only 30% of the income is attributable to the capital of the business and subject to the 25% rate. The remainder wold be taxed at individual rates as high as 39.6%, just like under current law.
3. Owners of service businesses — like accountants and lawyers — begin with the presumption that ZERO percent of their income is deserving of the 25% rate.

Senate Bill

The Senate bill takes a dramatically different approach in its effort to lower the tax burden on business owners. Under the Senate proposal, owners of sole proprietorships, S corporations and partnerships may take a deduction of up to 17.4% of their “qualified business income.” This deduction is limited to 50% of the wages paid to the owner by the business, the theory being that this will discourage owners from foregoing wages in favor of flow-through income taxed at a lower rate.

To illustrate, assume A is the sole owner of an S corporation that earns $280,000 during 2018. If the S corporation pays no wages to A, a deduction of 17.4% is not permitted, so A simply taxes the $280,000 of income at ordinary rates. If, however, the S corporation pays A an $80,000 salary, leaving $200,000 of flow-through income to A, A may claim a deduction of 17.4% of $200,000, or $34,800, as this amount does not exceed the wages paid to A.

This provision has the effect of reducing the top rate on flow-through income from 39.6% to 33%.

Also note, the 17.4% deduction is NOT available to owners of a “specified service business” — such as accounting, engineering, or law — unless the owner’s income is less than $75,000 (if single, $150,000 if married).

Observation

The House and Senate bills make one thing clear: if you are going to provide preferential treatment to flow-through income, there needs to be safeguards in place to prevent taxpayers from gaming the system by foregoing wages (taxed at a high of 39.6%) in exchange for the beneficial treatment afforded the business income.

The House bill attempts to curb abuse by creating a default setting where the income of nonpassive owners is treated as being 70% attributable to services, and is thus taxable at ordinary rates, with only the remaining 30% of the income taxed at the preferential 25% rate. With a top ordinary rate of 39.6%, this creates a top effective rate on nonpassive owners of 35% ((39.6% * 70%) + (25% * 30%)). And because owners of service providers generally owe all of their business income to their efforts, rather than capital, abuses are prevented under the House bill by subjecting the entire amount of the income to ordinary rates.

The Senate bill takes a different tack, offering a 17.4% deduction, but only if wages are paid out (or in the case of a partnership, guaranteed payments). This creates a top effective rate on flow-though income of 31% (38.5% * (100% – 17.4%). Like the House, the Senate bestows no benefit on the owners of service businesses once they outgrow the rather modest income thresholds ($75,000 if single, $150,000 if married).

Most interestingly, the Senate bill does not seem to differentiate between passive and nonpassive owners. This is a major criticism of the House bill — which applies the 25% rate on ALL income earned by passive owners — because it appears to provide incentive NOT to work. It appears — though it is not entirely clear — that passive and nonpassive owners will be treated the same under the Senate bill.

Individual Alternative Minimum Tax

Current Tax

After computing “regular” tax liability, taxpayers must compute an alternative liability using a parallel system, and then pay the greater of the two taxes.

House Bill

The alternative minimum tax is eliminated.

Senate Bill

The alternative minimum tax is eliminated.

Estate Taxes

Current Law

A tax of 40% is imposed on the value of a taxpayer’s assets in excess of $5.6 million ($11.2 million if married). The original GOP proposal would have eliminated the estate tax entirely.

House Bill

HR 1 immediate increases the exemption amount to over $10 million (over $22 million if married). After 2024, the estate tax would be eliminated entirely, while preserving a stepped-up fair market value basis to the heirs.

Senate Bill

The Senate proposal preserves the estate tax, but immediately increases the exemption amounts to over $10 million (if single, $22 million if married).

Observation

Refusing to repeal the estate tax may prove to be a nonstarter for many Senate Republicans, but it does generate much needed revenue that can be used to pay for tax cuts and preserve popular deductions like the one for medical expenses.

Corporate Tax Rates

Current Law

Corporate income is taxed at a top rate of 35%.

House Bill

Corporate income is taxed at a top rate of 20%.

Senate Bill

Corporate income is taxed at a top rate of 20%,but the rate is not dropped until 2019.

Observation

Many large business groups have long called for an immediate drop in the corporate rate. The Senate’s willingness to delay the cut by one year helps the score of the bill, but will win few fans among powerful corporations.

Treatment of Other Corporate/Business Items

Let’s look at this in table form:

Observation

The Senate bill is fairly consistent with the House bill, though businesses will lose many advantages — availability of the cash method, exceptions to the Unicap rules and percentage-of completion method — at lower revenue thresholds. In addition, the Senate bill is less generous with the Section 179 deduction, which will become important when 100% expensing sunsets in 2023.

The Senate bill does provide a depreciation break the House bill does not: the depreciable life of residential and nonresidential real property would be reduced from 27.5 and 39 years, respectively, to 25.

International Tax

Current Law

The U.S. currently operates under a deferral system. To illustrate, if a U.S. corporation, in search of greener tax pastures, sets up a subsidiary in a low-tax locale such as Ireland, any income earned by the affiliate in Ireland is not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend, at which point it will be taxed at rates as high as 35%. As a result, U.S. corporations feels little motivation to repatriate foreign income; this is precisely why there is reported to be as much as $2.5 trillion in assets attributable to U.S. multinational businesses stashed overseas, where it has yet to be subjected to U.S. tax.

House Bill

HR 1 would switch to a territorial system by providing a 100% dividends received deduction to U.S. corporations when amounts are repatriated from foreign subsidiaries. To prevent a windfall to those corporations who currently have cashed overseas that has yet to be taxed, however, a one-time “deemed repatriation” would be imposed, under which the U.S. corporation would pay tax of 14% on any cash stashed overseas and 7% on any illiquid assets.

Senate Bill

The Senate bill would also shift to a territorial regime, while embracing the concept of a deemed repatriation, only with rates of 10% on cash and 5% on illiquid assets.

Observation

It’s worth noting that the House bill originally started with repatriation rates of 12% and 5% before it became necessary to raise those rates to the present 14% and 7% in order generate additional revenue to make the bill fit within the budgeted $1.5 trillion in tax cuts.

What comes next?

The Senate bill has a bit of a problem. In order for the GOP to use the reconciliation process and pass its vision of tax reform without a single vote from a Democratic Senator, the bill needs to meet two standards:

1. The total tax cuts over the first 10 years can’t exceed $1.5 trillion, and
2. The bill cannot add to the budget deficit beyond the ten year window.

As currently constructed, the bill meets the first standard, but fails the second, as deficits are rising during the out years of the budget window. As a result, either changes will need to be made during the Senate Committee on Finance’s markup scheduled to begin on November 13th, or else 60 votes would be required out of the Senate, including at least 8 from Democratic Senators.