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Editorial 9 MIN READ

The House has passed the Tax Cuts and Jobs Act. The Senate is rewriting it.

A 227-205 floor vote on November 16, a Finance Committee mark that keeps seven brackets and repeals the individual mandate, and a pass-through fight that is still live

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What the House passed
  2. What the Senate Finance Committee is doing differently
  3. The pass-through fight, read from an LLC
  4. What is still up in the air
  5. What to do if you are forming an entity this quarter
  6. Sources

he House passed the Tax Cuts and Jobs Act on November 16, 2017 by a vote of 227 to 205. Thirteen Republicans voted no; no Democrats voted yes. The bill now sits in the Senate, where the Finance Committee ended its own markup on the evening of November 16 and reported out a version that looks similar on the corporate side and quite different everywhere else.

This is where the bill actually is as of this week, and what the two chambers still have to reconcile before anything reaches the President's desk.

What the House passed

Chairman Kevin Brady introduced H.R. 1 on November 2. The Ways and Means Committee opened markup on November 6 and worked through an amendment in the nature of a substitute plus three chairman's mark modifications over five days, reporting the bill out on November 9 on a 24-16 party-line vote. The full House took it up a week later under a closed rule and passed it within about forty-five minutes of floor debate.

The House bill does what the Big Six unified framework and, before it, the House Better Way blueprint signaled it would do, with the compromises you would expect once the thing had to clear a committee.

On the corporate side, the headline is a permanent 20% C-corporation rate, down from a top statutory rate of 35%, effective for tax years beginning after December 31, 2017. The corporate AMT is repealed. Section 179 expensing is expanded to $5 million with a $20 million phase-out, and full expensing is allowed for qualified property placed in service after September 27, 2017 and before January 1, 2023. The net interest deduction is capped at 30% of adjusted taxable income, with a small-business exception for businesses averaging under $25 million in gross receipts.

On the pass-through side, the House adopted a 25% maximum rate on "qualified business income" with guardrails designed to stop wage earners from recharacterizing salary as business income. The default rule treats 70% of a pass-through owner's active income as wages (taxed at ordinary rates) and 30% as business income (eligible for the 25% cap). Owners can elect out of the 70/30 default and instead compute a capital percentage tied to a deemed return on invested capital, currently set at the federal short-term rate plus seven percentage points. Specified service businesses, broadly the personal-services categories already familiar from section 1202 and the section 448 regulations, are excluded from the lower rate unless their owners elect the capital-percentage method.

On the individual side, the House collapses seven brackets into four: 12%, 25%, 35%, and a 39.6% top rate kicking in at $500,000 single and $1 million joint. The standard deduction roughly doubles. The personal exemption is repealed. The state and local tax deduction is capped at $10,000 and limited to property taxes only (income and sales taxes are no longer deductible). The mortgage interest deduction is preserved but capped on new loans at $500,000 of principal, down from $1 million. The individual AMT is repealed.

The estate tax is not repealed in the final House bill, though repeal was on the table in earlier drafts. The exemption doubles from the 2017 level of $5.49 million per person to roughly $11 million, indexed, with full repeal scheduled for 2024.

The Joint Committee on Taxation scored the House-passed bill at roughly $1.437 trillion in net revenue loss over the ten-year budget window (JCX-54-17, the distributional and revenue table dated November 16, 2017). The Tax Policy Center's preliminary analysis estimated that by 2027, after the phased-in changes fully took effect, the average tax cut would be concentrated in the top quintile, with a meaningful share of middle-income households facing a small tax increase relative to current law. The Tax Foundation's dynamic score was the outlier, projecting 3.5% additional long-run GDP and approximately 890,000 new full-time-equivalent jobs from the House version, with dynamic revenue feedback offsetting roughly a third of the static cost.

What the Senate Finance Committee is doing differently

Chairman Orrin Hatch released the Finance Committee's Chairman's Mark on November 9 and began markup on November 13. The committee worked through a modified mark dated November 14 and finished on the evening of November 16, voting the bill out 14-12. The Senate version is not a lightly edited House bill. It is a different bill in several structurally important places.

The corporate rate is the same 20% headline, but it is delayed by one year to tax years beginning after December 31, 2018. That one-year delay is a budget-window device worth roughly $100 billion over ten years in JCT's accounting and is likely to be the first thing conference negotiators argue about.

The pass-through mechanism is different. The Senate does not use a rate cap. Instead, it allows individual owners of pass-through entities a deduction equal to 17.4% of domestic qualified business income, taken against the regular individual rate schedule. The deduction phases out for specified service businesses above $150,000 joint / $75,000 single. For non-service businesses above the threshold, the deduction is capped at 50% of W-2 wages paid by the business. The arithmetic produces a different effective rate than the House's 25% cap at most income levels and for most business profiles; the two approaches will have to be reconciled in conference.

The Senate keeps seven individual brackets, not four. The top rate drops to 38.5% (from 39.6%), and the bracket thresholds widen. Most of the individual-side changes sunset after December 31, 2025, a concession to the Byrd Rule, which prohibits a reconciliation bill from increasing the deficit outside the ten-year budget window. The corporate changes do not sunset; the individual ones do.

The Senate retains both the corporate AMT and the individual AMT. The Senate bill as reported out of committee on November 16 also repeals the Affordable Care Act's individual mandate penalty, a late addition folded into the modified mark on November 14 that CBO scored as saving roughly $318 billion over ten years (November 8, 2017 CBO estimate), largely through reduced federal spending on premium tax credits and Medicaid as fewer people obtain coverage. The mandate repeal is not in the House bill. It is one of the more consequential policy differences and will be litigated in conference.

The Senate bill doubles the estate-tax exemption but, unlike the House bill, does not repeal the estate tax at any point. State and local tax deductibility is eliminated entirely in the Senate bill, including for property taxes. That is more aggressive than the House's $10,000 property-tax carve-out, and it is one of the items New York, New Jersey, and California Republicans in the House will likely insist be softened back toward the House version.

The pass-through fight, read from an LLC

The single most important question for an LLC or S-corporation owner reading the two bills is which pass-through mechanism survives conference. The answers are not interchangeable.

Under the House's 25% rate cap with the 70/30 default, a single-member LLC owner earning $300,000 in active qualified business income would see $90,000 taxed at the 25% business rate ($22,500) and $210,000 taxed at ordinary individual rates, with the exact ordinary-side liability depending on how the new four-bracket schedule applies to that dollar. Specified service business owners (lawyers, doctors, accountants, consultants, financial advisers, performing artists, and the broader section-1202-style list) cannot use the 25% cap unless they elect the capital-percentage method, which for most service businesses yields a small capital percentage and most of the income flows through as wages at ordinary rates.

Under the Senate's 17.4% deduction, the same $300,000 of QBI becomes $247,800 of taxable income from the business, taxed at the Senate's seven-bracket schedule. For a service business owner above the $150,000 joint threshold, the deduction is zero. For a non-service business above the threshold, the deduction is capped at 50% of W-2 wages the business paid; a one-person consultancy with no W-2 wages gets nothing, even if the business is non-service.

The two mechanisms were designed to solve the same problem (giving pass-throughs a rate benefit that roughly approximates the corporate rate cut) and produce quite different winners. The House version is more generous to mid-size owner-operated businesses with meaningful active income. The Senate version is more generous to capital-intensive businesses that pay W-2 wages and less generous to one-person service firms. Conference will have to pick one chassis or stitch together a hybrid.

Neither chamber's pass-through rule is easy to administer. The House's 70/30 default and capital-percentage election import a decades-old reasonable-compensation fight (the S-corp version of which is already a well-worn audit issue) into a brand-new statutory regime covering every partnership and sole proprietorship in the country. The Senate's W-2 wage cap and service-business phase-out create cliff effects that will reward reorganizations and punish small service firms that cross the threshold by a dollar. Whatever emerges from conference will need regulations before most taxpayers can rely on it.

What is still up in the air

As of this week, the bill is in the middle, not the end. The Senate has not yet taken its bill to the floor. Majority Leader McConnell has said the vote will come after Thanksgiving recess. The Byrd bath, the process by which the Senate parliamentarian strikes provisions that violate the reconciliation rules, has not yet formally run. Several provisions in the House bill would fail a Byrd challenge if moved directly into the Senate version; the individual-side sunsets in the Senate bill exist precisely to avoid that problem.

Senator Ron Johnson of Wisconsin has publicly declared he is a no on the Senate bill as drafted, citing the pass-through treatment as insufficient relative to the corporate rate cut. Senators Collins, Murkowski, Flake, Corker, McCain, and Daines have raised concerns of various kinds, including on the individual-mandate repeal, the deficit impact, the individual-side sunsets, and the pass-through rules. The Senate can afford to lose two Republican votes. It cannot afford to lose three.

The House bill and the Senate bill, if both pass their respective chambers, will go to a conference committee. Conference will likely resolve at least the following: corporate rate effective date, pass-through mechanism, individual bracket count, SALT treatment, estate tax repeal versus exemption doubling, individual AMT, and the individual mandate repeal. The conference report must then pass both chambers again. The Republican leadership has stated a goal of getting a bill to the President before Christmas. That is a real deadline but a movable one.

What to do if you are forming an entity this quarter

Anyone setting up an LLC, an S-corporation, or a C-corporation in November or December 2017 is forming under a tax regime that will probably change for the 2018 tax year. The reasonable posture is not to force the choice of entity now based on a bill that has not cleared Congress. The C-corp rate cut is in both bills; the pass-through mechanism differs sharply between them; the individual rates and bracket count differ; and the SALT treatment differs. None of the differences are small enough to bet on.

For a founder who would have formed a Delaware C-corp anyway because of an anticipated venture round, nothing in either bill changes that calculus; the Delaware formation math is unchanged, and the corporate rate cut, if it happens, is additional upside. For a founder choosing between an LLC and an S-corp on the current payroll-tax crossover math, the answer may shift once a final bill exists, but not in a direction anyone can responsibly predict from a House version and a Senate committee print. The cleanest move this quarter is to form the entity the business actually needs under current law and revisit the tax-status elections in the first quarter of 2018, when whatever emerges from conference will be law, regulations, or nothing.

Sources

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