On Friday afternoon after the close of business, Congress released the conference committee report for the Tax Cuts and Jobs Act of 2017.
The House then passed it on Tuesday and sent it to the Senate. It’s hard to imagine considering mere weeks ago we had only the broadest outlines of a proposal.
I’ve written many times about my concerns about both the House and the Senate bills: the massive increase to the deficit, the lack of a bipartisan process that would create broader support for the bill – and as Senate Majority Whip John Cornyn, R-Texas, observed, a better bill – and the cynical gimmicks used to mask the true cost of the bill.
While all these things are still true of the final product, there are a few things that got changed in the conference bill that are worth noting.
One of the biggest differences between the House and the Senate bill was their treatment of pass-through entities, which are companies that don’t pay the corporate income tax but instead “pass through” their profits to the owners, who then pay the individual income tax.
The House established a 25 percent rate for most pass-through income, with few limitations. Under this provision, passive investors were the biggest winners.
The Senate, in contrast, allowed pass-through entities to deduct up to 23 percent of their income, but limited it by having a wage test: The deduction was limited to 50 percent of the entity’s W-2 wages for all employees. (Cornyn also added a provision allowing certain publicly traded partnerships to be eligible for the provisions, regardless of their payroll.)
Under the Senate version, active businesses with employees have a clear advantage.
The conference version, as expected followed the structure of the Senate provision, lowering the level of deduction to 20 percent and keeping the wage test.
But, the final conference bill contains a key difference: An “or,” which combines wages paid plus 2.5 percent of the unadjusted basis in the pass-through entity.
So pass-through businesses would continue to calculate the deduction based on 50 percent of the companies wages or they would calculate the deduction using 25 percent wages plus 2.5 percent of the unadjusted basis, immediately after acquisition of all qualified property.
If want the plain English version, let me give you a couple of examples.
Say I have small business that I operate as a pass-through entity that generates $300,000 of income for me and I have a total payroll of $250,000. Using the wage test, I would compare half of my employees’ wages ($125,000) to 20 percent of my income ($60,000) giving me a reduced taxable income of $240,000; if my wages were just $100,000, I’d be able to deduct just $50,000 giving me a taxable income of $250,000. The idea behind the wage test was to ensure the change in the pass-through rules encouraged growth. Under current law, all $300,000 would be ordinary income, so this is big benefit for pass-throughs with employees.
Now let’s pretend I own a Limited Liability Corporation that owns two office buildings. I bought each building for $2 million and together they generate $500,000 in income each year; the entity also has a single part time employee who gets paid $50,000. Under the prior Senate version, using the wage test, I would only be able to deduct $25,000, leaving me with a taxable income of $475,000. Now let’s look at how the change made in conference alters that. First, I take $12,500 (25 percent of my W-2 wages) and 2.5 of my basis at the time of acquisition, or $100,000 (2.5 percent of $4 million). Now I get to deduct the full 20 percent from my taxable income, giving me a new, lowered taxable income of $400,000.
That is an enormous boon to real estate interests.
Previous reporting has indicated President Donald Trump and Sen. Bob Corker, R-Tenn., would benefit, but many others in Congress would likely benefit as well – a quick review indicates Sen. Ron Johnson, R-Wis., Rep. Darrell Issa, R-Calif., and Rep. Don Beyer, D-Va., all report significant income from real estate partnerships or limited liability companies.
Of course, members of Congress have business interests, and no matter how the bill shaped up, some of those members would benefit. But this looks like just another bow to special interests at the last minute.
It is just these kinds of conflicts and benefits that running the bill through regular order would have revealed. Open debate would have allowed the public to decide for themselves if the law was changed to benefit members of Congress themselves and favored industries, or because Congress truly believed it was the right policy.