The House Ways and Means Committee recently released a series of talking points that serve as an outline of the major features of the House tax bill, which is tentatively titled “the Tax Cuts and Jobs Act.” The House bill, which appears to be a synthesis of President Trump’s campaign tax plan and the House blueprint, appears at first glance to be a major tax cut for all U.S. taxpayers.
Upon closer examination, however, we can see that the House Bill is essentially a major tax cut for C corporations and small-business owners but a tax increase for many middle- and high-income taxpayers who currently rely on Schedule A itemized deductions to reduce their annual income tax liabilities.
What do these proposed tax changes mean for CFOs? For CFOs of large multinational corporations with a C corporation parent in the United States, the changes mean that (a) more cash can be distributed in the form of dividends from overseas subsidiaries at a significantly lower corporate tax rate and (b) only the corporation’s U.S.-source income will be subject to income tax.
For CFOs of large S corporations, limited liability corporations, and partnerships, the changes mean that the net business income that flows through to shareholders on Schedules K-1 will be taxed at a significantly lower individual income tax rate.
And CFOs of all entity types should be aware of the increased scrutiny that the Internal Revenue Service will likely apply to employee misclassification and contractor arrangements arising as a result of the sharp cut in the flow-through business tax rate.
1.Outline of Major Proposals
Here’s what we know so far about most of the major corporate tax changes in the bill:
- It will lower the highest corporate income tax rate for C corporations from 35% to 20%.
- It will lower the highest rate on “small-business income” — i.e., Schedule C and “pass-through” business income for sole proprietorships, LLCs, partnerships, and S corporations — from the taxpayer’s marginal individual income tax rate (currently as high as 39.6%) to a flat rate of 25%.
- It will shift from a worldwide tax system for U.S. companies — in which U.S. companies are taxed on their worldwide income — to a territorial tax system — in which U.S. companies are only taxed on their U.S.-source income.
- It will allow companies with foreign earnings held overseas to repatriate those earnings by paying a one-time repatriation tax of 12% for overseas cash holdings and 5% for overseas non-cash holdings.
2.Impact on C Corps. and Small-Business Owners
The House’s proposal to lower the highest corporate income tax rate from 35% to 20% is a game-changer with respect to existing C corporations and small businesses that would previously have been deterred from electing C corporation status.
Most small businesses are deterred from C corporation status because it imposes two levels of taxation on the same income — once at the entity level, when the income is earned, and again at the individual level, when the corporation distributes the income to its shareholders in the form of a dividend.
With the highest corporate income tax rate currently at 35% and the highest individual tax rate on qualified dividends currently at 20%, the highest aggregate income tax rate is 55%.
But if the C corporation income tax rate is reduced to 20%, the highest aggregate income tax rate will be 40% (20% corporate tax and 20% individual income tax on dividends), which is only 0.4% higher than the highest individual income tax rate of 39.6 percent. Thus, existing and prospective C corporations stand to benefit significantly from the sharp decrease in the corporate income tax rate.
C corporations with international operations also stand to benefit under the House bill because of the proposed shift to a territorial tax system. This is a major shift for large C corporations with a significant amount of income earned overseas, because that overseas income would not be subject to U.S. income tax.
Further, U.S. parent corporations of foreign subsidiaries also stand to benefit significantly from the House bill because of the one-time repatriation tax on profits earned overseas. The current rule is that a foreign corporation’s income is not taxed in the United States until the foreign corporation pays a dividend to its U.S. shareholders.
If the U.S. shareholder happens to be a C corporation, the foreign-source dividend would currently be subject to tax at a corporate income tax rate of 35%. If the C corporation wanted to distribute the foreign-source dividend to its shareholders, then the shareholders would pay a second level of tax at either a 15% (for all but the highest individual tax bracket) or a 20% (for those in the highest individual tax bracket of 39.6%) rate.
Under the House bill, those foreign subsidiaries would be able to distribute foreign earnings in the form of dividends to their U.S. parent companies at a much lower tax rate (12% for overseas cash and 5% for overseas non-cash holdings) at the corporate level.
Small-business owners, such as LLC members, limited and general partners, S corporation shareholders, and (possibly) sole proprietors, also stand to benefit significantly from the House bill. Ordinary business income that flows through to shareholders and partners on Schedules K-1 (and possibly to sole proprietors and owners of disregarded entities on Schedules C) would be taxed at a 25% tax rate instead of the shareholders and partners’ marginal tax rates, which could be as high as 39.6%.
The risk for the U.S. Treasury in this situation is that some wage earners who would otherwise be classified as W-2 employees could be tempted to misclassify the wages as Form 1099 income or to channel the earnings through an S corporation or single-member LLC.
As Neil Irwin of the New York Times notes, “[b]y taxing pass-throughs at the lower rate, the new plan creates tremendous incentive for any upper-income person to find a way to structure that income as pass-through-business income rather than wages.” The House Bill will apparently offer some safeguards to protect against this tax-avoidance strategy, but we do not yet know what these safeguards might be.
CFOs should be aware that middle- and high-income W-2 employees stand to lose the most under the House bill because of the proposed elimination of most Schedule A itemized deductions. Eliminating most Schedule A deductions will increase the tax bill for certain taxpayers who rely on high itemized deductions to reduce their taxable incomes.
For example, the home mortgage interest deduction will be capped for future home purchases at $500,000 and the state and local tax deduction will be capped at $10,000. Middle- and high-income homeowners who live in high income tax and high property tax states such as New York will no longer be entitled to claim 100% of their state and local taxes — this means that the tax bill for these taxpayers is likely to increase if the House bill is enacted.
The reduction in Schedule A itemized deductions appears to be a means to pay for the corporate tax cuts rather than a means to simplify the tax code or reduce special-interest deductions, as President Trump claimed they were.
President Trump’s one-page tax plan called to “[e]liminate targeted tax breaks that mainly benefit the wealthiest taxpayers.” But the benefits of most-line item deductions on Schedule A are not limited to wealthy taxpayers.
For example, taxpayers who claim Schedule A deductions for medical expenses over the 10% floor of adjusted gross income and unreimbursed employee business expenses over the 2% floor of AGI are not taking advantage of loopholes for wealthy taxpayers. All taxpayers who itemize get the benefit of these deductions regardless of their income levels. The real targeted tax breaks for the wealthiest taxpayers are not found in Schedule A, but in Form 6251: Alternative Minimum Tax, which the House bill proposes to eliminate.
There is no question that the House bill represents what would be the most significant overhaul to the U.S. Tax Code since the Tax Reform Act of 1986. Reducing the corporate tax rate to 20% and the flow-through business tax rate to 25% and shifting to a territorial corporate tax system would completely change the current tax landscape for U.S. companies and offer a more competitive tax rate, one that might incentivize foreign corporations to increase investment in U.S. subsidiaries.
But in the wake of these major corporate tax overhauls, CFOs must retain honest expectations regarding the likely impact on middle- and high-income employees. Those taxpayers who stand to gain the most under the House bill are taxpayers on the marginal ends of the economic spectrum.
Tax liabilities will be decreased for (a) low-income, non-homeowners, because of a proposed increase in the standard deduction and (b) the wealthiest taxpayers who derive the majority of their income from flow-through investments, like S corporations and partnerships, because of the decrease in the flow-through business tax rate and the repeal of the AMT.
But middle and high-income homeowners who derive the majority of their income from W-2 wages — including many C-level executives — will likely experience an increase in their annual income tax liabilities.
Matthew A. Morris is a partner at Bowditch & Dewey LLP.