While allegations of sexual harassment by our nation’s leaders dominated the headlines (again) last week, many may have missed a rather significant development: the passing by the House of a bill that would make pretty significant changes to our tax system. The Senate is currently working on its own tax reform bill, and there seems to be a real possibility that this Congress will pass tax reform. The House and proposed Senate tax bills make pretty major changes in the way that businesses are taxed. Here are some of the most important proposed changes:
1. Major Cut to the Corporate Income Tax Rate.
The House bill cut income tax rates for corporations from 35% to 20%. This is a flat rate that applies to corporations of all sizes, unlike the current system where small businesses pay a lower tax rate. The bill also increases the amount of deductions that can be taken under section 179 of the Income Tax Code, which permits small businesses to deduct capital expenditures. The bill increases this limit from $500,000 to $5 million over the next five years.
2. Repeal the Alternative Minimum Tax for Corporations.
The Alternative Minimum Tax is an odd separate tax system that is ostensibly is designed to prevent wealthy taxpayers who may take a bunch of deductions from paying little to no tax. It is determined after the standard income tax is computed, and it applies a 20 percent tax rate to an alternative definition of taxable income. If it is higher than the standard income tax, then it must be paid instead. In practice, it has penalized certain businesses that do not earn high profits. The House bill would eliminate this tax, thereby simplifying the tax system.
3. 25% Maximum Tax on “Pass-Through” Entities.
A “pass-through” entity is a partnership or an S-corporation, which does not pay a separate business income tax like a C-corporation, but instead just requires partners and business owners to pay tax on the business’s profits at their individual income tax rate. Currently, the highest individual rate is 39.6%, which is what partners and shareholders in S-corporations pay on those businesses profits. The tax reform bills would lower this tax to 25%. Pass-through entities also will no longer be able to deduct from their federal tax bill state and local taxes that they pay. C-corporations will still be permitted to deduct these taxes, however.
4. Reductions in the Amount of Interest that Businesses Can Deduct.
Businesses with more than $25 million in revenue can now only deduct business interest expenses that exceed the sum of their business interest income plus 30% of their adjusted taxable income.
The tax reform bills would expand the use of the cash method of accounting for small businesses by increasing the $5 million threshold for corporations and partnerships (with a corporate partner) to $25 million. The cash method of accounting allows businesses to recognize income and deduct expenses when the cash is received or paid, rather than having to accrue income and expense. The bill would also change the accounting rules for inventories and long-term contracts.
6. New Taxes on Profits and Assets Earned and Held Abroad.
The tax reform bills would impose a 10 percent tax on money shifted to overseas subsidiaries. It would also subject all untaxed income currently held overseas to a 10 percent rate for money held in liquid assets like stocks and bonds and 5 percent for immovable assets like buildings and factories. There will also be a 12.5 percent minimum tax imposed on profits that foreign subsidiaries of US companies earn from intangible assets like patents and copyrights.
It is certain that the House bill and the proposed Senate bills will not become law in their current forms. However, the changes outlined above are the centerpieces of the tax reform proposals, and it is hard to see Congress signing off on any bill that does not include at least most of these reforms to the tax code. Stay tuned to our blog for updates on these tax reform bills.