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Tax reform likely to occur early next year

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With Republicans controlling both houses of Congress and the White House, the likelihood that tax reform will be a high legislative priority in 2017 is virtually assured.  Both President-elect Trump and the House Republicans have put out fairly detailed blueprints of how they would like to reform the nation’s tax laws.  Although there are differences, their proposals are more alike than they are different. Even though the Senate Republicans have not put out a proposal of their own, there is widespread support for tax reform among Senate Republicans as well.  The clear belief on the part of President-elect Trump and Congressional  Republicans is that tax reform is critical if the economy is to grow at a faster rate than it has in recent years, so expect to see action, probably significant action, early next year.

This document describes the two leading comprehensive tax reform proposals, the proposals set out by President-elect Trump during the presidential campaign and the proposals set out by the House Republicans in June of 2016 as part of their “Better Way” proposal.

Individual tax reform

Both President-elect Trump’s and House Republicans’ proposals for individual tax reform have the same overarching themes of achieving comprehensive tax reform by lowering tax rates for everyone and broadening the tax base by reducing or eliminating deductions and credits. 

Under both proposals, the current seven rate brackets would be reduced to the same three rates:

 

Individual tax rate proposals

Donald Trump

12 percent, 25 percent and 33 percent

House Republicans

12 percent, 25 percent and 33 percent


Both proposals also would increase the standard deduction from the current levels ($6,300 single/$12,600 married filing jointly) to dramatically higher levels.  In theory, this would lead to simplification because the increased standard deduction would be high enough that many taxpayers would  no longer itemize deductions.

 

Standard deduction proposals

Donald Trump

$30,000 for married and $15,000 for single

House Republicans

$24,000 for married, $18,000 for single with a child and $12,000 for single


Although fewer taxpayers would choose to itemize if the standard deduction is raised, both proposals keep at least some level of itemized deductions. The proposals differ in this area, but both propose to limit itemized deductions compared to current law. This would be a substantial simplification over the current system, which has different limits for different deductions and a phase-out based upon adjusted gross income.

 

Itemized deduction proposals


Donald Trump

  • Cap itemized deductions at $200,000 for married and $100,000 for single
  • ‘Close special interest tax breaks’


House Republicans

  • Allow only mortgage interest and charitable deductions
  • Repeal state and local tax, medical and miscellaneous deductions

 

In addition to standard and itemized deductions, the current individual income tax system provides for personal exemptions of $4,050 per dependent and contains complicated credits related to child and dependent care. The proposals differ slightly in these areas, but both recognize that changes are necessary to simplify this area of the tax law and to help the middle class with expensive child care costs.

 

Exemptions and child and dependent care proposals


Donald Trump

  • No specific proposal on personal exemptions
  • Add the following:
    • Above-the-line deduction for average child care costs  (limited to taxpayers with income of $500,000 or below for married and $250,000 or below for single)
    • Rebates for low-income taxpayers
    • Available to stay-at-home parents
    • Dependent Care Savings Account for $2,000/year–low-income eligible for $500 federal match
    • Six weeks of guaranteed maternity leave through the unemployed insurance system
  • $5,000 elder care deduction


House Republicans

  • Replace personal exemptions with a tax credit of:
    • $1,500 per child
    • $500 for other dependents


Currently, capital gains are taxed at preferential rates of 0, 15 and 20 percent, depending upon the taxpayer’s general tax bracket. In addition, since 2013, taxpayers with income over certain threshold levels pay an additional 3.8 percent net investment income (NII) tax on income such as capital gains, interest, dividends, rent and passive business income. As explained below, both proposals would change various aspects of these rules, but would continue to tax capital gains at a lower rate than ordinary income. Both proposals would eliminate the 3.8 percent NII tax.

 

Capital gains proposals


Donald Trump

  • Eliminate 3.8 percent tax on NII
  • Retain 0, 15 and 20 percent preferential rates


House Republicans

  • Eliminate 3.8 percent tax on NII
  • Exclude 50 percent of gain from income, resulting in rates of 0, 6, 12.5, and 16.5 percent


Similar to capital gains, under the current system, certain “qualified” corporate dividends are taxed at 15 or 20 percent, while interest (along with other forms of portfolio income) is taxed at ordinary income rates. The president-elect’s proposal does not address dividends and interest other than to eliminate the 3.8 percent NII tax.  The House Republicans’ proposal would continue to effectively tax qualified dividends at capital gains rates by excluding half of such amounts from income.  The House Republicans would also make a very significant change by extending that 50 percent exclusion to interest income.

 

Dividends and interest proposals

Donald Trump

No proposal


House Republicans

  • 50 percent exclusion from income
  • Rates: 6 percent, 12.5 percent and 16.5 percent


Both proposals would eliminate the alternative minimum tax (AMT).  Aside from the effects on bottom-line tax liabilities, this would eliminate the complexity of requiring taxpayers to compute their taxes, or potential taxes when planning a transaction or change in personal status, under two different systems.

 

AMT proposals

Donald Trump

Eliminates

House Republicans

Eliminates


Both proposals would entirely eliminate the federal estate tax. If enacted, this  would be the first time the estate tax would be permanently eliminated since its introduction in 1916. The House "Better Way" document cites figures that show taxpayers spend almost as much money trying to minimize and comply with the estate tax as the government collects from the tax.  For this reason, they view the repeal as a net plus for the growth of the overall economy with a relatively small revenue cost.  While President-elect Trump also proposes to repeal the estate tax, his proposal contains a significant difference from the House Republican proposal.  The House Republicans would also continue to allow assets transferred at death to avoid income taxation by allowing the basis of a decedent’s assets at death to receive a step-up in tax basis to fair market value for the heirs.  The president-elect would tax the appreciation on assets held by a decedent to the extent the appreciation exceeds $5 million ($10 million for a couple).

 

Estate tax proposals


Donald Trump

  • Eliminate
  • Capital gains held at death subject to income tax with a $10 million exemption for married and $5 million for single


House Republicans

  • Eliminate
  • Retain step-up in basis


Although the president-elect’s proposal is silent on certain other topics, the House Republicans set out the goal of improving the effectiveness and efficiency of the earned income credit, incentives for higher education, and the highly complex rules applicable to retirement savings.  The earned income credit is available to lower earning taxpayers but has been plagued by concerns about credits and tax refunds erroneously granted due to noncompliance with program rules. The rules governing higher education incentives have become increasingly complex, and the retirement savings rules are among the most complex in the tax law and are also subject to regulation by the Department of Labor. Although these topics are highlighted in the House’s blueprint, there are no specifics explaining how the rules of current law would be modified.

Business tax reform

Both President-elect Trump and the House Republicans have proposed dramatic changes to the corporate tax system in an effort to make the country globally competitive. As with individual tax reform, the main theme of corporate tax reform is to lower the rates of all businesses while eliminating certain deductions and credits. In addition, the proposals would make major changes to the rules governing U.S. taxation of corporate earnings generated outside of the United States and to the way business assets are depreciated.

One of the most significant changes proposed by both President-elect Trump and the House Republicans is to lower the tax rates for corporations and for businesses operated as pass-through entities, like partnerships, LLCs, and S corporations. The president-elect’s proposal would lower rates more than the House Republican proposal, which means that it would reduce overall tax collections by a larger amount if enacted in its current form. 

The details of President-elect Trump’s proposal with respect to how pass-throughs would be taxed is unclear at this time. What is clear is that some portion of the earnings would be taxed at a 15 percent rate.

 

Corporate tax rate proposals

Donald Trump

15 percent

House Republicans

20 percent

 

 

Pass-through tax rate proposals


Donald Trump

  • 15 percent
  • Large pass-throughs would also pay dividend taxes


House Republicans

  • Normal ordinary income rates would apply to a minimum amount of reasonable compensation paid or imputed to business owners providing services for the entity, with a 25 percent tax imposed on the remaining portion. 
  • Pure investors in pass-through businesses would be taxed at a 25 percent rate.


In addition to lowering the rates, both plans hope to spur capital investment by allowing immediate expensing for property (other than land) rather than relying on the current complicated depreciation system. To remove the incentive to debt-finance these purchases to get an interest deduction and immediate expensing, both proposals would also change the availability of interest deductions. Part of the reason for  removing a deduction for business interest expense is to remove the current bias in the tax law for debt over equity.

 

Depreciation proposals

Donald Trump

Choice between: (1) current law, or (2) immediate expensing for tangible and intangible property (not land), with no deduction for interest expense 

House Republicans

Immediate expensing for tangible and intangible property, but not for land

 

 

Interest expense proposals

Donald Trump

No deduction if immediate expensing is elected

House Republicans

Deduction allowed, but only to the extent of interest income


In addition to spurring investment through immediate expensing of property purchases, both proposals retain the research and development (R&D) tax credit that was made permanent at the end of 2015.

 

R&D credit proposals

Donald Trump

Retained

House Republicans

Retained


As noted above, the overall theme is to reduce rates and broaden the tax base. To broaden the base, both proposals state  that deductions or credits would be eliminated. Interestingly, although both proposals mention eliminating various tax expenditures, the only deduction specified in either proposal is the domestic production activity deduction (DPAD).

 

Business deduction proposals

Donald Trump

Eliminate corporate tax expenditures (unspecified)

House Republicans

Repeal certain business deductions (unspecified other than the DPAD)


Similar to the individual tax changes, both proposals eliminate the corporate AMT. One interesting area of difference in the proposals is that President-elect Trump would eliminate the current preferential treatment of carried interest, while the House Republican proposal is silent on this issue.

The one area in which there is a substantial difference in the proposals of President-elect Trump and the House Republicans is with respect to the taxation of foreign earnings of U.S. businesses.  Currently, the United States taxes the worldwide income of U.S. companies, allowing a foreign tax credit to prevent double taxation on income that is already taxed in another country. However, income earned in a foreign country is not subject to U.S. tax  until it is reinvested (repatriated) in the United States. Many multinational companies reinvest their foreign earnings abroad, or hold them in cash pending future reinvestment, with the result that the earnings are indefinitely and arguably permanently exempted from U.S. tax.

This issue was extensively covered in the media throughout the election, and it is  estimated that approximately $2.6 trillion of untaxed foreign earnings are sitting abroad. Both proposals would impose tax on the accumulated foreign earnings of U.S. businesses that have not yet been repatriated and taxed by the United States. Taxes would be imposed whether the earnings are repatriated or not, although there would obviously be no compulsion to keep them overseas once they were taxed.  The House Republican proposal would spread the tax over eight years, while President-elect Trump’s proposal is silent on when the tax would have to be paid.

 

Current accumulated foreign earnings proposals


Donald Trump

  • 10 percent tax


House Republicans

  • 8.75 percent tax on cash
  • 3.5 percent tax on remainder (non-liquid assets)
  • Paid over eight years


In addition to addressing past foreign earnings, both proposals would change the system with respect to  future foreign earnings. However, the proposals in this area are substantially different. President-elect Trump would continue to make U.S. corporations taxable on their worldwide income and would eliminate the deferral of tax on foreign or overseas income, although he would continue to allow a tax credit for taxes paid to foreign jurisdictions where the profits were generated.  However, the overall U.S. corporate tax rate would be lower, as explained above. 

The House Republicans propose switching to a territorial system, which essentially does not tax U.S. corporations on their income earned in foreign countries. 

 

Overall international tax system proposals


Donald Trump

  • Retain taxation of worldwide income
  • Eliminate deferral of tax on foreign earnings
  • Provide credit for foreign taxes paid
  • End inversions


House Republicans

  • Territorial system taxing only U.S.-source income
  • Border adjustment for exports and imports (i.e. impose tax on imports and rebate tax on exports)

 

Conclusion

While  the tax reform proposals of both President-elect Trump and the House Republicans provide  a clear outline of where they would like to go, many details are unknown at this point in time.

The Republican leadership in the House has made it clear that they would like to take up tax reform efforts in early 2017.  Although their proposal and President-elect Trump’s proposal are very similar, they are not identical, and those differences will have to be worked out, which will take some time. To move tax reform legislation quickly through the Congress, it is likely that a fast track process known as reconciliation will be used. This would allow the legislation to move forward without being subject to a filibuster in the Senate. No decision on this matter has been announced at this point, and it likely will not be decided until early 2017.   It also is important to remember that although tax reform is a high priority for both  Congress and President-elect Trump, there are many other issues such as health care reform and immigration reform that may impact the timing of when tax reform will be considered by Congress.

While it is impossible to predict what will happen with respect to tax reform  and the timing of when it will happen, taxpayers would be well-served to understand the details of the leading tax reform proposals and to consider what action they may want to take in anticipation of potentially significant changes in the tax law.

All other things being equal (which they never are of course), taxpayers engaged in planning should expect the future to bring lower marginal tax rates and the elimination or limitation of some existing deductions and credits.


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