The latest SBLC Report from the Small Business Legislative Council (SBLC) returns to the question of what may be ahead for tax reform in the U.S.

How much is comprehensive tax reform likely to cost? Of course, no one knows for sure but the estimates for Trump’s tax plan during the first decade are between $5 to 7 trillion with the estimates for the House Blueprint Tax Reform plan (“Blueprint plan”) running at about half that amount. However, when using dynamic scoring (i.e., taking into account the positive response of taxpayers to better tax laws) and optimistic forecasts of robust growth, the cost of the Blueprint is supposed to drop to less than $200 billion during the first decade. The Blueprint itself says that “it envisions tax reform that is revenue neutral.” Wherever there is a difference between the Trump plan and the Blueprint, we’re betting that in most cases the provision that will cost less will end up in the final legislation to keep costs down.

Assuming the cost is closer to $3-5 trillion than zero, how is Congress going to pay for comprehensive tax reform? We’re betting that Congress won’t pay for it. There have only been four times in history that the Republicans controlled the House, Senate and the White House, and in recent times this has lasted for only a few years. (For the history buffs, this previously occurred from 1921-30, then from 1953-54 when Eisenhower was president, and for a short time from 2001-02 and 2003-06 when George W. Bush was president.) Our thinking, confirmed by a number of key players on the Hill, is that the Republicans are going to try hard to capitalize on the opportunity that they know will exist for at least the next two years in order to reform the tax laws the way they want. Look for the deficit hawks to be asked to stand down while tax reform goes through the way the majority of Republicans want. There are several controversial items in the Blueprint, such as the border adjustability provisions and the elimination of deductions for interest payments (see below), so it is unlikely that the leadership will want to add how to pay for tax reform into the mix.

How will the Blueprint and Trump’s plan reform business taxes?

Reduced Business Tax Rates – major change for pass-through entities and sole proprietors.

Blueprint: A new concept, “active business income” from pass-through entities and sole proprietors is capped at a 25-percent tax rate. Active business income is the income remaining after deducting the “reasonable compensation for services” for the owner(s). This means that for owners of a pass-through entity, an amount equal to a reasonable compensation for the owners’ services would be taxed at the regular personal income tax rate for each owner and the remainder of the income generated by the company would be considered to be “active business income,” which would be taxed at a rate no higher than 25 percent. This is a concept that the SBLC started promoting years ago.

Tax rate for C corps would drop to 20 percent.

Trump’s plan: Business tax rate drops to 15 percent for both C corps and “active business income” for pass-through entities. It appears that the same active business income concept from the Blueprint is included in Trump’s plan for pass-through entities though Trump’s rate would be 10 percent less than that in the Blueprint.

There are lots of questions surrounding how “active business income” and “reasonable compensation for services” would be determined. If we end up with a lower tax rate on active business income, it’s easy to imagine the slew of new regulations, IRS challenges and court cases, particularly on what is considered to be “reasonable” compensation. Ultimately though, the concept is sound.

Businesses allowed to expense investments:

Blueprint: All U.S. businesses would be permitted to expense investments in all tangible and intangible assets, except land. But note—the Blueprint eliminates the deduction for interest expense associated with the debt incurred to finance the investment (though it can be deducted up to the corporation’s interest income). More on this below.

Trump’s plan: Manufacturers would be able to deduct 100 percent of asset acquisition and production costs but would not be permitted to deduct interest expenses.

AMT would be eliminated under both plans.

Border Adjustability:

Blueprint: The corporate tax would not apply to exports while corporations would no longer be able to deduct the cost of imported items—meaning imports would be subject to corporate tax. Clearly the intent here is to encourage exports and discourage imports. This provision is intended to raise over $1 trillion in tax revenue over ten years. It is, however, causing a feud within the GOP as it pits companies like General Electric, Boeing and pharmaceutical companies (i.e., exporters) against Wal-Mart, Target and other retailers as well as the auto industry (i.e., net importers). Koch Industries has said that the Blueprint would “adversely impact American consumers by forcing them to pay higher prices on products … they use every single day.” They also warn that gas prices would “skyrocket.” In fact, a new coalition representing the importers, called “Americans for Affordable Products,” maintains that this tax would force companies to pass it on to the consumers, thereby raising prices. One can see how an export-focused company might end up with significantly reduced taxes, at the expense of the importers and their consumers paying additional dollars. Ways and Means Chair Kevin Brady (R-TX) has sent out warning signals that this provision is key to raising revenue and without it the tax rates envisioned in the Blueprint would have to be increased.

Trump’s plan: Trump’s plan would impose tariffs on imports from other countries, which many economists believe could lead to unnecessary trade wars with our friends. Our read is that Trump is walking away from this proposal and is moving in the direction of the Blueprint.

There are other changes to the international tax rules which are designed to stop inversions (U.S. corps becoming “owned” by foreign companies to avoid U.S. tax) and to bring back a lot of the dollars stored offshore by U.S. companies.

Most “special interest deductions and credits” other than the R&D credit would be eliminated. This would raise revenue and theoretically level the playing field.

Employer-Based Retirement Plans:

Blueprint: Current tax incentives will be maintained but Ways and Means is directed to consolidate and reform the multiple retirement options “to provide effective and efficient incentives for savings and investments.” The employer-based retirement plan community has developed a number of ideas for simplification over the years, but this language appears to indicate that the flexibility that is now in the system and welcomed by employers would be diminished. Tax-free savings accounts are also mentioned in the Blueprint—these accounts would have no restrictions on removing the money. If the proposal lowering the tax rate on “active business income” for pass-through entities becomes law then some modification on the tax rate for distributions from a retirement plan would be required, in order to keep these plans viable from a tax viewpoint. It’s hard to imagine small-business owners getting excited about a deduction for retirement plan contributions at a 25-percent rate and being taxed later at the personal rate of 33 percent. Unless distributions were also taxed at a 25-percent rate, it would be reasonable to assume business owners would close down the retirement plan and take the funds out at the 25-percent rate and then invest the dollars in assets which would be taxed at capital gains rates.

NOLs will be allowed to be carried forward indefinitely and LIFO will be preserved. The Blueprint directs Ways and Means to continue to “evaluate options for making the treatment of inventory more effective and efficient in the context of this new system.”

What would be the likely impact of eliminating the deduction for interest? Both Trump’s plan and the Blueprint favor equity over debt financing. At a minimum, this would have a significant impact on the real estate and financial industries. The Blueprint asks Ways and Means to “work to develop special rules for banks, insurance and leasing companies to take into account the role interest income and expense plays in their industry.”

The devil is in the details! Until we see the actual legislative language, we really don’t know how many of these provisions will actually work. Our guess is that as tax reform goes through Congress that the tax rates will end up higher and the deductions and credits will be reduced and that’s assuming that the Republicans in Congress can coalesce behind one plan. Because of the budget reconciliation process, many of the provisions may be phased in slowly over the ten-year budget window.

Outside factors, most notably what’s going to happen with replacing the ACA, could also have a significant impact on the timing and likelihood of tax reform.

Read Part 1 of this report here.

The mission of the SBLC, of which PPAI is a member and for which PPAI President and CEO Paul Bellantone, CAE, serves as a board director, is twofold: to make improvements in public policy for small business and to help member associations in their communications with business members. Note that this report is for the sole personal, informational use of PPAI members and should not be posted to any website.