On April 26th,
the Administration proposed the “biggest tax cut and reform in U.S. history” as
part of a drive to spur economic growth. Some estimates have put the loss in tax
revenues at $6.2 trillion over 10 years!
There is an obvious clash in priorities between the Administration and
the Republican House of Representatives who are concerned about the Federal
deficit. Some pundits see the proposal
as an “opening gambit” or bargaining position to cut a tax-reform deal with
Congress. Complicating matters is that
unless the Senate passes tax-reform with at least 60 votes, then the new law
will need to “sunset” in 10 years. The
10-year sunset rule is termed the “Byrd rule” named after the long-time senator
and applies to legislation that increases the deficit for longer than 10
years. What will businesses and
individuals do if the new tax law is only temporary? This country dealt with a similar issue with
the 2001 tax cuts under Pres. George W. Bush.
The temporary nature of the 2001 tax cuts created large uncertainties
and caused regret among some taxpayers who engaged in protective tax planning
strategies that ultimately proved to be unnecessary. Some commentators have said that the loss in
tax revenue might only be sustainable for two to three years! In that case, the tax cuts won’t drive a
change in business strategy or structure, it will just be a tax give away.
Let’s look at some
of the major proposals. These are
generalized comments as there are no details yet. The effective date is also unknown but might
reasonably be assumed to be January 1, 2018.
Cut the Corporate Tax Rate from 35% to 15%
Corporations
taxed as “C” corporations pay income tax.
The top tax rate is 35%. The
proposal drops the rate to 15%. There
will likely be a trade-off in the loss of certain deductions such as interest
expense. But these details are yet to be
worked out. C corporations will want to
defer income into the next tax year and accelerate deductions into the current
year.
Cut the “Pass-Through” Business Tax Rate from 39.6% to
15%
Business that
are conducted through partnerships, limited liability companies taxed as
partnerships, and Subchapter S corporations are considered “pass-through”
entities. Pass-through means that the
requirement to pay income tax on the business profit is passed through to the
owners of the business. Individual
owners include the business profit in their personal income tax returns. This change is a necessary coordination with
the C corporation tax rate cut; otherwise, pass-through entities would be
incented to become C corporations for the tax savings. It is uncertain whether businesses operated
as a sole proprietorship would also benefit from the 15% rate. It is also somewhat uncertain whether the net
profit would have to be left in the business to benefit from the lower rate or
if there would be a special carve-out of the lower rate in the individual income
tax return for the pass-through business income. An interesting issue concerns whether
post-reform depreciation recapture upon the sale of a business asset will
benefit from the 15% tax rate when depreciation deductions received a much
higher tax rate benefit.
Cut the Top Individual Tax Rate from 39.6% to 35% and
Reduce the Number of Rate Brackets
Currently the
top individual income tax rate is 39.6% which was originally set under Pres.
Bill Clinton, then reduced to 35% by Pres. George W. Bush, and then reinstated
to 39.6% under Pres. Barrack Obama. Now
the see-saw drops back to 35%. The
trade-off is the loss of certain tax deductions. The strategy for 2017 would be to defer
income into 2018 and to accelerate deductions into 2017. With the dramatic difference between the
proposed business tax rate and the individual tax rate, there will be some
incentive to convert personal income (such as compensation) into business
income.
Currently there
are seven tax rate brackets and the proposal reduces the number of brackets to
only three: 10%, 25%, and 35%. The income level for these brackets has not
yet been determined.
Eliminate All Itemized Deductions Except Home Mortgage
Interest and Charitable Contributions
Currently,
itemized deductions include medical expenses, state and local income taxes,
sales tax, real and personal property tax, home mortgage interest, investment
interest, charitable donations, casualty and theft losses, unreimbursed
employee expenses, accounting and legal advice for tax planning or compliance,
investment expenses, gambling losses, and estate tax on income with respect to
a decedent. The loss of all but the home
mortgage interest and charitable contribution deduction will have a large
impact on some taxpayers. As an example,
those living in states that impose high income tax or property tax will be
adversely affected. However, in many
instances, such taxpayers are subject to the alternative minimum tax (see
below) and do not actually benefit from many of these itemized deductions. The loss of these deductions coupled with the
repeal of the AMT could leave some of these taxpayers better off. Assuming a January 1, 2018 effective date, taxpayers
should consider prepaying their 2017 state income tax to get the deduction
before its repeal.
Importantly,
there is no mention of Pres. Trump’s campaign promise to limit total itemized
deductions to $100,000 for single filers or $200,000 for joint filers.
Double the Standard Deduction
The 2017
standard deduction is $6,350 for single; $9,350 for head of household; and
$12,700 for joint filers. Doubling the
standard deduction will simplify tax returns for many moderate-income taxpayers
by eliminating the need to itemize deductions.
Furthermore, there will be some impact from the loss of itemized
deductions other than home mortgage interest and charitable contributions. Itemizing will be beneficial only when those
two types of deductions exceed the higher standard deduction. No information was provided regarding the
personal exemption.
Repeal the Alternative Minimum Tax (AMT)
The AMT is a bad
tax. Enacted many years ago to prevent a
limited number of high-income taxpayers from avoiding income taxes all
together, the AMT has morphed into a tax that is paid by over 33 million
moderately high income taxpayers. The
AMT applies even if a taxpayer’s only deductions are the personal exemption and
state and local income and property tax!
Repealing the AMT will go a long way toward simplifying the tax law, but
it will cost the government a lot of tax revenue.
One specific
problem that may be addressed in the legislative details is what happens to
taxpayers with an AMT credit carryover.
For example, some taxpayers have exercised compensatory incentive stock
options (ISOs) to purchase employer stock.
When an ISO is exercised and the stock is held for investment, there is
no regular tax but there is AMT. When
the stock is later sold, there will be regular tax but that tax will be reduced
by the AMT paid earlier (the AMT credit) when the ISO was exercised. If there is no transition rule to preserve
the AMT credit, then such taxpayers may wish to sell their ISO stock before the
effective date of the repeal in order to avoid a double tax.
Repeal the Net Investment Income Tax (NIIT)
The NIIT was
enacted under the Affordable Care Act (Obamacare) in 2013. For the first time a payroll-type (Medicare)
tax was applied to interest, dividends, capital gains, rents, etc. This 3.8% tax is proposed to be
repealed. The rationale given for this
repeal is to “restore” the top long-term capital gain tax rate back to 20% from
23.8%, inferring that there is no proposal to change the top capital gain tax
rate. Repealing the NIIT suggests that
those contemplating a sale of a capital asset may want to defer the sale until
after the repeal in order to benefit from the lower tax rate, assuming
investment considerations don’t dictate an earlier sale. Capital loss harvesting this year will be
important in order to offset realized capital gains that otherwise would be
taxed at the higher 2017 tax rate.
It is uncertain
whether the additional 0.9% Medicare tax rate on earned income, enacted as part
of the ACA, is also proposed to be repealed.
Eliminate the Estate Tax
Many
conservatives have longed for the repeal of the “death tax.” Eliminating the estate tax will have
complicated interactions with the gift tax and the “step-up in basis” for the
income tax. It is uncertain whether the
generation skipping transfer tax is also proposed to be repealed. These details are yet to be worked out. Taxpayers should not take permanent steps,
such as canceling life insurance policies earmarked for the payment of estate
tax, until there is some certainty in the law.
But the problem is that the tax law is never certain. A future administration and Congress could
simply re-enact the estate tax, and it could be difficult for taxpayers who
canceled their life insurance, for example, to gain new coverage. In addition, if tax reform is enacted with a
10-year sunset provision, the estate tax will reappear at that time. The temporary estate tax repeal will benefit the
estates of those likely to die during that time frame, but for the younger and
healthier taxpayers, estate tax repeal will literally mean nothing as they will
outlive the ten-year time frame!
Importantly,
there was no mention of Pres. Trump’s campaign proposal to impose capital gain
taxes on estates with assets over $10 million.
Review of Recent Tax Regulations
In addition to
tax legislative proposals, Pres. Trump issued an executive order on April 21st
directing Treasury Secretary Mnuchin to review all “significant tax
regulations” issued on or after January 1, 2016. The objective of the review is to increase
simplicity, fairness, and pro-growth regulations.
Two major
regulations in the estate tax area could be in for review: 1) the complex “basis consistency”
regulations (issued March 3, 2016) and 2) the controversial and pro-IRS
valuation discount regulations (issued August 2, 2016). Identification of the tax regulations to be
reviewed is to be made by the third week in June with specific recommendations
due by the middle of September to mitigate the burden imposed by such
regulations.
