Unclear midterm outcome means uncertainty about taxes

The probability of Republicans gaining a narrow majority in the House after this week’s midterm election, combined with lingering uncertainty about which party will control the Senate next year, has tax experts hypothesizing what will happen in Congress during the lame-duck session through December and over the next two years.

“I’ve been thinking about this in two timeframes, the lame duck and then ’23 and ’24,” said Dave Kautter, a former acting commissioner of the IRS and assistant secretary for tax policy at the Treasury Department who is currently federal specialty tax leader at RSM US. “In the lame duck, it seems to me there are three business provisions that are front and center, which are deferring R&D expensing, deferring the change in interest expense deduction rules from EBITDA to EBIT, and then deferring the phasedown of 100% bonus depreciation, which starts next year.”

The changes from earlier legislation restricting deductibility of R&D and interest expenses took effect this year, and 100% bonus depreciation begins to go down next year. Kautter believes there is a great deal of bipartisan interest in deferring all three provisions during the lame-duck session before the end of the year, although some Democrats have said they won’t support any business tax changes unless there are changes on the individual side, primarily in the Child Tax Credit. The enhanced version of the Child Tax Credit in the American Rescue Plan Act of 2021 provided monthly payments to families in the latter half of the year, helping lift many out of poverty, but those ended last December.

Congress will also need to deal with the remaining set of tax extenders that traditionally need to be passed by the end of the year. For many years, there were dozens of temporary tax breaks that needed to be extended almost annually, but the Tax Cuts and Jobs Act of 2017 and several later legislative packages have since made most of them permanent.

“There’s only a handful of those left at this point,” said Kautter. “I counted up about 10, and those are things like incentives for mine safety training and the capital depreciation period for racehorses. I don’t know that they’re going to provide much of a motivation, but the one I think has the highest likelihood of passing in the lame duck is the retirement legislation, the EARN Act, as it’s called in the Senate, or some people call it Secure 2.0. That’s a bipartisan bill and it’s passed. The House and Senate have slightly different versions, but it’s come out of the committees in the Senate and it’s paid for, so it’s revenue neutral. That’s probably not controversial and not subject to a lot of negotiation.”

He thinks the business incentives, the Child Tax Credit and the extenders will probably pass by the end of the year. The Child Tax Credit may not be as generous as it was in 2021, given worries about the impact on inflation, but it has become a priority for some lawmakers. 

“Some Democrats have staked out the position that they won’t support the business changes without something on the Child Tax Credit,” said Kautter. “It’s so expensive, and I think the best that they could get would be maybe a year or so of enhanced Child Tax Credit, and I don’t expect it to be retroactive. I would expect it probably to be FY 2023. But there is a substantial interest in the Democratic caucus on doing something on the Child Tax Credit and some of the studies have said it’s had a significant impact on poverty in the country, so I think that will enhance the argument.”

Both parties will likely want to get those provisions out of the way before the next Congress has to deal with them. 

“It seems clear that no matter who controls the House and the Senate, it will be a very narrow majority,” said Kautter. “There may be a desire on the part of both parties to clear the decks for the beginning of next year. In other words, avoid starting in January with a backlog of these sort of tax issues to work on in the new Congress. If they can get agreement on them this year, get them out of the way and start with a clean slate next year.”

Senate control

Negotiations over a year-end deal will be occurring when all eyes will be on Georgia during the Dec. 6 Senate runoff between incumbent Democrat Raphael Warnock and Republican challenger Herschel Walker.

“With the Senate in balance, neither party is going to have the obvious maximum leverage,” said Jen Acuna, principal in federal legislative and regulatory services at the Washington national tax practice of KPMG LLP, who was a former chief tax counsel on the Senate Finance Committee and tax counsel on the House Ways and Means Committee, during a Twitter Spaces event on Wednesday. “It’s really going to be a question mark. That could be a recipe for, hey, nobody feels emboldened and everyone knows there’s a must-have deal, or it could also be a recipe for no deal.”

As for whether or not the tax extenders make it into a bill, that may hinge on whether there will be a big omnibus spending bill at the end of the year. “I tend to think if there is a deal, you’re going to see tax extenders at the end of the year,” said Acuna. “That’s something that has bipartisan support every year. Some of them have significant bipartisan support.” 

She believes the R&D expensing provision in particular, which expired a year ago, will get the heaviest demand. “I think that if there is an end-of-the-year deal, and neither party has the maximum amount of leverage some desire, that they could potentially be willing to come to the table to make a year-end deal that includes some extenders,” said Acuna.

“It’s an interesting question as to whether or not a deal can be made,” said John Gimigliano,  principal-in-charge of federal legislative and regulatory services in the Washington national tax practice of KPMG US, who was formerly senior tax counsel at the House Ways and Means Committee. “Is there a version of the Child Tax Credit that both sides can agree to that is not as large as the American Rescue Plan version that was enacted early in the Biden administration, but something that Democrats can still get a win on? That’s what I think they’re going to be talking about in December, some negotiation around that. I’m not convinced it really impacts the year-end negotiation as much as some people might suggest it would. It will impact 2023 in a big way depending on who controls the Senate. They have got to pass government funding. Nobody wants a shutdown.”

Looking ahead

In 2023 and 2024, Congress will be dealing with other issues, including changes from this year’s Inflation Reduction Act and 2017’s Tax Cuts and Jobs Act. Kautter doubts there will be any lifting of the $10,000 limit on state and local tax deductions in the TCJA, as a disproportionate share of the benefits skew toward higher-income taxpayers. However, Republican gains in high-tax states like New York and California could convince more GOP lawmakers in the House to support a rollback of the limit, as Democrats in those states have hoped. In any case, it’s set to expire in 2025, along with most of the other individual tax provisions from the TCJA, along with many for businesses as well.

“I think the likelihood of a change in the state and local tax deduction is zero or less,” said Kautter. “The Republicans will be interested in talking about the importance of extending the TCJA provisions, but most of them don’t expire until the end of 2025, so there’s no need to get that done in 2023 or 2024.”

One topic that Congress will be dealing with is funding for the IRS. The Inflation Reduction Act that Democrats pushed through Congress in August included an extra $80 billion in funding for the IRS over 10 years, but Republicans have threatened to block the funds or at least limit how much the IRS can spend on extra enforcement and tax audits.

“The tool that the Republicans potentially have there is to reduce the annual appropriation for the IRS and to say you get $80 billion to spend over 10 years and your average annual appropriation for the next three years is 12 and a half, so this year it’s five,” said Kautter. “I don’t know if that’ll happen, but there’s been some discussion about whittling back on what the IRA did for IRS funding in that manner. I see 2023 and 2024 involving substantial debate and highlighting issues for the presidential campaign, but the likelihood of significant action is pretty small.”

New IRS commissioner

On Thursday, the White House announced its intention to nominate Daniel Werfel as the next IRS commissioner (see story). Werfel was previously acting commissioner of the IRS and controller of the White House Office of Management and Budget during the Obama administration and is currently working in the private sector at the Boston Consulting Group.

Kautter was also acting commissioner of the IRS for about a year during the Trump administration while simultaneously serving as assistant secretary of the Treasury in charge of tax policy. He doubts Democrats will be able to push through the nomination during the lame-duck session with so much else on Congress’s plate to get through before the end of the year.

“Anything is possible on Capitol Hill, but I think that timeframe is pretty ambitious,” said Kautter. “I used to work in the Senate years ago and, when Russell Long was chairman of the Finance Committee, he used to say, ‘If I got the votes, I can change the time on the clock up there.’ If the Democrats want to take the time and effort, it would be very unusual to rush through the nomination that quickly, and I think the Republicans want to take a close look at his work, not because they’ve got any questions about his background. I think they’re just curious as to what his views are.”

Werfel has a background in change management from his work in the consulting field, and that’s probably going to be helpful at the IRS, which is under pressure from both parties to make big changes. While the Inflation Reduction Act includes funding targeted at improving taxpayer service, modernizing the IRS’s antiquated technology systems and bolstering enforcement, the IRS was also tasked with some of these same priorities under the Taxpayer First Act of 2018. If Werfel does win confirmation, he can expect to receive heavy oversight from lawmakers. Republicans in particular are demanding action on some of their unmet requests, such as the leak of confidential taxpayer information to the investigative news site ProPublica, which has run a series of articles called the Secret IRS Files about the tax strategies used by the wealthy.

“I think there’s a desire within the IRS itself and among its leaders to change, so he could be the right person at the right time for leading that change,” said Kautter. “I do think the oversight will be intense if the Republicans get one of the two houses of Congress. There’s concern that the IRS and Treasury haven’t been as responsive to other requests that have been made as they’d like, for example, the ProPublica leak. It’s baffling to me why the IRS doesn’t have that figured out. It hasn’t disclosed anything. They’ve been working with the DOJ and I think other agencies trying to identify it. The IRS systems and the individual master file are very detail oriented. In other words, they can tell you who looked at whose return and when they looked at it, so to have these large amounts of data that have been extracted from IRS files and the IRS can’t seem to figure it out is a matter of great concern. I think there’s also some suspicion on the part of some the IRS knows and just won’t say. But when you don’t respond, that’s when people start to imagine the worst, and then they’ve sent a whole series of other letters that they haven’t gotten responses to. They’re really focused on trying to bring a little more transparency to what’s going on at the IRS, how they spend the money and what their priorities are with the $80 billion. That’s going to be a key area of focus. Whoever is commissioner needs to be prepared to spend a lot of time on Capitol Hill talking to both the members themselves and in committee hearings.”