House and Senate Reconciliation on Tax Reform?
Given the turbulent year Congress has experienced to date, it’s anyone’s guess as to where the House and Senate will come to an agreement on a reconciliation bill regarding tax reform. However, if tax reform passes this year, the impact will be significant on both the business community and individuals.
While most observers are focused on the possibility of a significant reduction of the corporate tax rate to 20 (or 22)%, other provisions in the proposed tax bill will impact businesses in a meaningful way. The owners of “pass-through” entities (LLCs and S Corps) would see significant reduction in their taxable income. With those pass-through earnings currently taxed at ordinary income, proposed revisions would allow an approximate 23% deduction to “qualified pass-through business income” that would lower the effective personal rate to 27% to 29%. However, service companies (e.g., law, accounting, investment, firms) would not be able to utilize this deduction. The deduction would also be limited to 50% of W2 earnings for these taxpayers.
While corporations would benefit from lowering the current corporate tax rate to 20% or 22%, various deductions would be eliminated as a trade off for the reduction. Chief among these would be restrictions on the amount of interest expense business owners could deduct. Essentially, the expectation is that interest expense deductibility would be limited to 30% of EBITDA. However, non-deductible interest expense would be allowed as an expense carryforward. For instance, for PE buyers of assets who utilize high levels of leverage and exceed the 30% cap, this carryforward feature might allow for the deductibility of interest expense on highly levered businesses as they de-lever during the hold period.
Finally, after over a decade of discussion, it appears the House and Senate are in agreement on new rules concerning General Partner (“GP”) compensation for Private Equity and Hedge Funds. While a number of the details are still uncertain, it appears Congress’ intent is to require GP’s pay ordinary income on any GP earnings for holdings of less than three years. Investments held longer than three years would still qualify for capital gains tax treatment.
There are meaningful changes in the proposed bill for tax rules regarding Executive Compensation but those details have not been agreed upon. It is expected that there will be limitations on certain deductions for “excess” Executive Compensation. Personal tax rates would also generally be reduced for the majority of tax payers along with restrictions on certain deductions such as mortgage interest and state and local taxes.
While the bill’s passage isn’t guaranteed, political observers expect passage given Republicans’ strong desire to pass at least one major piece of legislation this year.