What We Know So Far about Latest Tax Plan
The Unified Framework for Tax Reform was released on September 27, 2017. This framework represents a joint effort by members of the Trump Administration (Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn) and Congressional leadership (the chairmen of the House Committee on Ways and Means and the Senate Committee on Finance, the Speaker of the House and the Senate Majority Leader). It marks the beginning of the arduous process of significantly overhauling the Internal Revenue Code (“IRC”) for the first time since 1986.
Despite the involvement of the Congressional committee chairs in developing the framework, it leaves almost all details for the committees to flesh out. It is also possible that the legislation that is ultimately passed will differ in one or more ways from the framework that was released.
Some members of Congress have already expressed concern that the plan would increase the deficit. If the details of the plan do not offset tax savings with enough revenue to make it revenue neutral, it may be difficult to gather enough votes to pass both houses of Congress. Lawmakers may also resort to built-in expiration dates for certain provisions in order to overcome some procedural hurdles, as it did to pass the tax cuts enacted during President Bush’s administration in 2001.
The new framework has everyone asking what the newly released tax plan means for them. How does it differ from the tax code that’s in place now? What does it hope to accomplish?
Without knowing what dollar thresholds will apply to the various tax brackets, or what details will come out of the House and Senate committees, it is still too early to determine how much you could save (or lose) if the plan is enacted. But whether you are the owner of a large corporation or you file a Form 1040-EZ to report wages, something in the plan is likely to affect you, and this alert should help you understand which provisions those are.
Goals of Tax Reform
President Trump laid out four core principles as the foundation for tax reform, as stated in the framework:
- Make the tax code simpler, more fair, and easier to understand
- Allow American workers to keep more money in their paychecks
- Make America a “jobs magnet” by making tax rates more competitive with other countries
- Encourage offshore investors keeping money offshore to “reinvest in the American economy” (page 2)
According to the framework, there are five main goals that the Administration and the Republican Party hope to achieve through major tax reform:
- Tax relief for middle-class families
- The simplicity of “postcard” tax filing for the vast majority of Americans
- Tax relief for businesses, especially small businesses
- Ending incentives to ship jobs, capital, and tax revenue overseas
- Broadening the tax base and providing greater fairness for all Americans by closing special interest tax breaks and loopholes
(page 3, Unified Framework for Tax Reform)
Here’s what we know so far about what could change for taxpayers under the administration’s tax reform framework as presented.
Fewer individual tax brackets
Instead of seven tax brackets, the highest one being 39.6 percent, this plan proposes three tax brackets (12 percent, 25 percent and 35 percent) and suggests that a fourth may be added for the highest income taxpayers. (NOTE: Because this plan doesn’t include the income levels for each bracket, it is difficult to predict winners and losers.)
It is possible that the middle class won’t see their tax rates move much either way, since many already fall in the 25 percent or 28 percent brackets. Some of the lowest economic earners, who are only paying 10 percent now, could see their tax rate go up by 2 percent but may actually save taxes as a result of the increased standard deduction. The highest earners (presumably certain individuals or families making over $418,400 per year), would see their tax rate go down from 39.6 percent to 35 percent. To put that in perspective, someone making $500,000 a year could save about $23,000 if nothing changed other than his or her tax rate.
Deductions and credits for individuals
The framework aims to double the standard deduction and both increase the Child Tax Credit and expand the number of families who benefit from it. It also calls for the creation of a new $500 tax credit for dependents who are not children to benefit people taking care of parents or others. Conversely, the framework suggests the elimination of personal exemptions and additional standard deductions currently available to elderly and blind individuals.
Doubling the standard deduction and expanding dependent and child credits could benefit many lower and middle income taxpayers who are more likely to claim the standard deduction on their tax returns than to itemize deductions and who do not currently lose the benefit of credits due to income limitations. However, the value of the increase in the standard deduction to taxpayers with multiple dependents may be offset by the loss of personal exemptions for these dependents.
The framework also “eliminates most itemized deductions” in an effort to “simplify the tax code” (page 5, “Itemized Deductions”), but it doesn’t specify which deductions will be eliminated. It specifically retains tax incentives for home mortgage interest and charitable contributions. These deductions are maintained because they are seen as helping to “accomplish important goals that strengthen civil society, as opposed to dependence on government” (page 5). These are also deductions that disproportionately favor middle and upper income taxpayers, as they generally have larger mortgages and more disposable income available to support charitable causes.
At the same time, a loss of deductions such as state and local income and property taxes and investment expenses would likely have the largest impact on middle and upper income taxpayers (who are more likely to be home owners and own investment property) and taxpayers in states with high income taxes and property values, such as New York, New Jersey and California. While the framework doesn’t specifically call for these deductions to be eliminated, they are the ones that have been most often discussed.
The framework also states an intention to maintain and/or simplify provisions for encouraging higher education and saving for retirement, but it does not provide any direction to the legislative committees as to how to achieve this. Some analysts believe that Congress may eliminate the current deduction for retirement plan savings in favor of making future withdrawals from these plans non-taxable.
The end of the Estate and Alternative Minimum Taxes
The tax reform framework would eliminate the Estate Tax, the Generation Skipping Transfer Tax and the Alternative Minimum Tax (“AMT”). The Estate Tax only affects about 0.2 percent of all estates, because it usually only kicks in if the estate in question is worth over $5.49 million. The Generation Skipping Transfer Tax only impacts a small portion of those.
However, it’s likely that a repeal of the Estate and Generation Skipping Transfer Taxes will be offset by an end to the current practice of treating inherited assets as having been acquired for their date of death value. If this happens, it may complicate matters for everyone and cause estates or heirs to incur additional costs to determine the carryover tax basis of inherited assets. They may need to figure out how much a decedent paid for something many years ago and review other financial and tax records that may not exist or be readily accessible. An accurate determination of basis might also hinge on access to the decedent’s tax returns.
Besides making the determination of basis more complicated for heirs, a change to the rules regarding the basis of inherited assets may also ultimately cost lower- and middle-class families tax dollars. The very wealthy may find that while they are faced with significant difficulty in determining the basis of inherited assets, any financial costs associated with this is offset by Estate Tax savings.
For example, imagine that an individual’s only asset is a stock that was purchased for $100,000 and is worth $1,000,000 upon death. If she had never made any taxable gifts, current rules could result in no Estate Tax being paid, because the estate is worth less than the exemption amount. There would also be no tax due if the heir sells the stock for $1,000,000, as he would receive a step-up in basis of the stock. However, if legislation eliminates both the Estate Tax and the step-up in basis, a sale of the stock for $1,000,000 would result in taxable gain of $900,000 and potential tax of $214,200.
The tax reform framework does not include any changes to the Gift Tax.
The AMT was passed as a way to make sure that people with higher incomes would have to pay some taxes despite deductions such as those related to state income and property taxes and investment expenses. In 2017, the U.S. raised about $38 billion through the AMT. Repeal of the AMT would greatly simplify the tax filings of many taxpayers.
Reduced tax rates for businesses large and small
President Trump wants to cut the maximum corporate tax rate to 20 percent. The Administration has indicated that this rate is non-negotiable. This rate is higher than the 15 percent originally suggested in April 2017 but lower than the 22.5 percent this report cites as the “average of the industrialized world” (page 7). Lowering the corporate tax rate would, in theory, make the U.S. more competitive with the rest of the world, creating jobs and increasing wages. The current maximum effective corporate tax rate is 35 percent.
The framework also proposes eliminating the AMT for corporations and suggests that the tax writing committees should consider ways to lessen the burden of the double taxation of corporate earnings, which would be consistent with the practice in many countries. However, it does not provide any specifics as to how to achieve this goal.
Many small, management or family-owned businesses are taxed as pass-through entities, meaning they end up paying the individual tax rate (as high as 39.6 percent) instead of the corporate tax rate on their business income. This tax reform plan would cap the tax rate on income from these businesses at 25 percent. That lower rate could mean significant tax savings for the owners who may currently pay tax based on the highest individual tax bracket.
There is concern that lowering the rate could lead to individuals trying to reclassify personal income as business income. The authors of the framework noted this and expect Congress to provide safeguards to prevent this from happening. However, it is still likely that careful planning and documentation can help taxpayers maximize the benefits available from a new rate structure, should this part of the framework become law.
Reducing the tax rates on businesses creates a need to offset the loss in tax revenue by getting rid of many deductions and tax credits that businesses regularly take advantage of. While the framework purports to keep business credits for research and development, most other credits and tax incentives could be on the chopping block or at least up for negotiation. One deduction that is specifically marked for repeal is the domestic production activities deduction currently allowed by IRC Section 199.
The business credit section of the framework also specifically mentions an intention to retain the low-income housing tax credit, although in practice this credit is normally generated by pass-through entities and claimed on their owners’ tax returns.
Business investments in capital assets
The framework calls for expensing depreciable assets (other than structures, such as buildings) acquired during a period of at least five years and partially limiting interest deductions for C corporations.
The framework is silent as to what percentage of interest expense may be disallowed or how the proposed reduction to the deduction for interest expense may be applied to pass-through entities.
These provisions seem to be a compromise. In earlier tax reform discussions, there was a debate between allowing businesses to write off, or expense, large-ticket items as soon as they buy them (versus writing off a little bit each year based on a depreciation schedule) and getting a deduction for the interest on the business loans often used to pay for those expenses and to finance debt. At issue was the perception that the first tax incentive was more likely to encourage investment, while the tax deduction for loan interest would be more akin to subsidizing businesses.
Ending the treatment of carried interest as capital gains
In an interview on CNBC on September 28, 2017, National Economic Council Director Gary Cohn said that while it isn’t in the framework, President Trump wants to change the treatment of carried interest. The share of profits that private-equity managers, venture capitalists, hedge fund managers and some real estate investors get from the funds they manage and participate in is referred to as “carried interest.” Under current tax law, income from carried interest is often treated as capital gains, which can be taxed at a rate as low as 23.8 percent (taking into account the NIIT). If carried interest were treated as regular gross income, the top tax rate could be as high as 39.6 percent. Treating all carried interest as ordinary income would be seen as getting rid of a loophole for the wealthy, one of President Trump’s stated goals, and could help raise tax revenue to offset reductions elsewhere.
Bringing back corporations and earnings from overseas
Over the last several years, some high profile corporations have moved their headquarters (and many jobs) overseas, or established subsidiaries overseas, seeking a lower corporate tax rate. President Trump wants to reverse this trend and predicts that businesses will return to the U.S. and take advantage of the new, lower corporate tax rate, thus stopping the flow of businesses and jobs going overseas.
The framework includes a proposal for a low, one-time tax be applied to any profits and wealth accumulated overseas, followed by an ability to repatriate foreign earnings from 10 percent owned subsidiaries without incurring additional income tax. It suggests that separate tax rates be applied to liquid assets and illiquid assets with the tax to be paid over several years after the passage of the legislation. It defers the determination of the appropriate number of years to the tax writing committees.
The framework suggests imposing a low tax rate on all foreign profits of U.S. multinational corporations earned after the passage of legislation, followed by an income tax exemption for dividends received from foreign corporations.
These proposals could remove the current incentive to keep profits offshore, since U.S. income taxes would be paid on them either way.
Most analysts agree that this tax reform framework favors tax cuts for wealthier Americans while not doing as much for middle and lower income taxpayers. There are also concerns from both sides of the aisle about how much this plan could add to the national deficit.
Is there anything you should change about what you’re doing right now? Not necessarily. Given the gridlock in Congress, it’s hard to say what details may be contained in a final tax reform bill – and when any bill would become effective. Our normal advice regarding deferring income and accelerating deductions still stands in most cases. If you do not normally contribute the maximum amount possible to qualified retirement plans, you may want to make sure you do so this year. That way, in case future deductions become non-deductible, you will have received one last year of tax savings.
If you have any questions about what you should be watching for in the coming months, or you have questions about your current tax situation, call your local Cherry Bekaert advisor to start a conversation. Tax reform or no tax reform, we’ve got your back – as well as answers to help guide you forward.