On the horizon: Tax reform
Year-end tax planning taking into account possible tax reform in 2017
INSIGHT ARTICLE |
Both President-elect Trump and House Republicans have released far-reaching tax reform proposals. With Republicans controlling both houses of Congress and the White House in 2017, the likelihood of enactment of significant tax reform next year has increased significantly. Although the proposals differ in some respects, they share a common vision: lower tax rates and fewer deductions for both individuals and businesses. It is important to bear in mind that proposed reforms are just that, proposed. Given the increased likelihood of tax reform next year, however, taxpayers would be well-served to consider the potential impact of these proposals as they engage in year-end tax planning.
Highlights from the proposals
|Three tax brackets for individuals (12%, 25%, 33%)||Reduce corporate tax rate|
|Repeal alternative minimum tax (AMT)||Reduce rate for pass-through earnings|
|Allow a 50% exclusion for investment income||Allow immediate expensing for capital expenditures|
|Repeal 3.8% net investment income tax (NIIT)||Create a territorial tax system|
|Repeal estate tax||Tax existing foreign earnings|
Planning considerations and opportunities
In the sections below, we have set out examples of various planning opportunities that taxpayers may want to consider as they do their year-end tax planning this year. The planning ideas and considerations are meant to serve as examples of the types of opportunities available and to help initiate conversations between you and your tax advisor. There are numerous exceptions, downsides, and other considerations that are not mentioned; thus, each of the items must be carefully analyzed in light of a taxpayer’s unique facts and circumstances.
Individual tax planning
In general, from a tax planning perspective, it is usually better for taxpayers to defer income to the future to avoid paying income tax as long as possible and to accelerate deductions to get the benefit of reducing taxable income as soon as possible. This strategy must be carefully employed if a taxpayer is or may become subject to the alternative minimum tax (AMT). Given that the two leading tax reform proposals involve lower individual tax rates and some limitation on itemized deductions in the future, taxpayers may want to consider deferring income from 2016 to future years to not only defer the payment of tax, but also to possibly pay tax at a lower rate. Similarly, taxpayers may want to accelerate as many deductions as possible into 2016 to not only get the benefit of the deductions sooner, but also to get a greater tax benefit since tax rates may be lower in the future. It is critical that taxpayers take into account the AMT in making these decisions. In addition, taxpayers may also want to consider:
- Ensuring that contributions to 401(k)s and other retirement plans are maximized for 2016
- Taking capital losses this year to offset gains
- Deferring capital gains unless there are sufficient loss carryforwards to offset the gains
Estate tax planning
In addition to income tax planning, taxpayers anticipating taxable estates, or what would be taxable estates under the current law, should continue to address estate and gift tax considerations during their year-end tax planning. While both leading tax reform proposals call for repeal of the estate tax, they do not directly address gift tax, and the President-elect’s proposal calls for taxing the appreciation in assets held at death by a decedent, which is a significant departure from current law.
Taxpayers should be very careful in reversing any part of their existing estate plans, e.g., surrendering estate-liquidity life insurance policies, until the future of the estate and gift tax is clear. However, this doesn’t mean the possibility of repeal should be ignored. For example, taxpayers who have already made lifetime gifts exceeding the lifetime exclusion amount may wish to defer or carefully structure upcoming large gifts in order to avoid “pre-paying” an estate tax that may soon be repealed.
Accounting methods and periods
In years such as this, where tax rates are expected to be lower in the future, a key planning consideration for businesses as well as individuals is the deferral of income to a future tax year (to be taxed at a potentially lower tax rate) and accelerating deductions to offset current-year income (which may be taxed at a higher tax rate). In analyzing whether and how to achieve these objectives, taxpayers may wish to consider:
- Having a cost segregation study done for buildings for 2016 to identify assets that may be depreciated more quickly than the building itself
- Partially disposing of assets when a portion has been repaired or replaced (especially if that repair or replacement is required to, itself, be capitalized)
- Accepting a negotiated settlement for bad debt owned by the taxpayer, thereby potentially allowing a write-off of that reduction as partially-worthless debt
- Structuring upcoming sales transactions as installment sales
- Reviewing revenue accounts for advance payment income that qualifies for deferral to 2017
- Segregating any subnormal goods and offering them up for sale at their net realizable value before year end, potentially allowing for a write-off in 2016
- Electing the last-in, first-out (LIFO) method of accounting for inventory.
In an effort to defer income and accelerate deductions, pass-through entities and their owners may wish to consider:
- Finding ways to create basis for owners with suspended losses (such as creating new shareholder loans or having partners guarantee existing debt)
- Deferring December loan repayments to avoid triggering gain for owners who previously used debt basis to take losses
Given the proposed 50 percent exclusion for interest income, pass-through entities may also wish to consider deferring interest payments on shareholder/partner loans until after the first of the year (if allowed by the loan agreement).
Finally, given the preferential tax rate the leading tax reform proposals afford to C corporations, some pass-through entities may wish to begin modeling different C corporation conversion scenarios now. That way, if and when tax reform makes C corporation status more attractive, the entities will be able to move quickly and maximize the benefit of that change.
Net investment income tax
The prospect of this tax’s repeal makes income deferral and deduction acceleration especially powerful tools given that income may be deferred to a year where the tax no longer exists and deductions, which could potentially provide zero NIIT benefit in 2017, can be accelerated to 2016 where they could benefit the taxpayer. Taxpayers subject to the NIIT may want to consider:
- Prepaying state taxes to maximize the allowable state tax deduction
- Harvesting capital losses to offset capital gains
- Looking for opportunities to reach 101 hours of participation (to exclude from the NIIT income from activities that would otherwise be classified as passive)
- Grouping new businesses or business interests together with similar existing activities in order to reach the requisite active participation hours
Planning considerations for international tax focus primarily around the proposal to allow repatriation of foreign earnings at a reduced rate and the proposal for a territorial tax system. In light of these potential changes, taxpayers with international operations or investments may want to consider:
- Selling nonfunctional currency denominated debt with built-in losses in order to recognize those exchange losses in the current year
- Triggering balance sheet foreign exchange losses by transferring money from a foreign branch whose currency has depreciated against the U.S. dollar to the home office of that foreign branch
- Deferring the repatriation of offshore earnings until 2017
- Deferring dividend payments from an IC-DISC
Compensation and benefits
As a preliminary note, while repeal of the Affordable Care Act (ACA) has been mentioned, employers do need to ensure that they are complying with all requirements of the ACA until such time as any changes are signed into law and take effect.
As for income tax planning ideas, employers may want to consider establishing a cash balance pension plan before the end of 2016, which allows for tax-deductible contributions for shareholders and other key employees that greatly exceed the maximum allowable contributions to a 401(k) plan. Some employers may be considering changing the timing of employee compensation payments in an attempt to have that income subject to a potentially lower future tax rate; however, employers should be aware that there are a number of rules that restrict the ability to achieve that result. Finally, employees who have unexercised, vested stock options should compare the benefits gained from exercising under a potentially lower tax rate in future years to the risk of additional taxable income if the stock price rises prior to exercise.