President-Elect Donald Trump's surprise victory last month has generated significant interest in his vision for how tax reform will help, to borrow from his campaign theme, Make America Great Again. The unexpected speed with which he is filling his cabinet, the Republican control over both the House and the Senate, and the many similarities between his plan and one proposed earlier this year by House Republicans all serve as indicators that he has the resolve and potentially the means to follow through with his vision.
Trump's tax plans are housed on his website, and while portions are provided in detail, others are somewhat general or even vague, leaving us to interpret their meaning and speculate their impact. The plans also have been changed more than once since they were first rolled out during the campaign, and undoubtedly will change again. The purpose of this article is to share an overview and analysis of his tax plans based on the current information available.
Executive summary
- Due to potentially lower rates and reduced deductions applying next year, consider deferring income to next year and accelerating deductions into this year.
- The proposed 20% capital gain tax will apply at lower income levels than the 15% capital gain tax applies this year, and those who are in the 15% bracket may want to trigger gains this year.
- Charitable contributions may be worth more in 2016 than under the Trump plan. Taxpayers may want to establish a donor advised fund this month to maximize their deductions and preserve the ability to identify the ultimate donee at a future date.
- Taxpayers subject to the AMT (alternative minimum tax) in 2016 may want to defer expenditures that are not deductible under AMT rules until 2017. Common examples include miscellaneous itemized deductions and state/local income taxes.
- Owners of pass-through entities may need to alter how they compensate themselves, because wages and guaranteed payments could be subject to higher taxes than pass-through income under Trump plans. Owners who fund significant income tax payments via withholding from wages may need to shift to use of quarterly estimates.
- If capital gains, instead of estate values, are taxed at death, estate planning could be replaced with capital gain planning and existing estate plans will need to be completely overhauled.
- Taxpayers involved with a pending asset sale that will close this year should consider deferring payment until next year. At that time, they can decide whether to defer gain and pay taxes at potentially lower 2017 rates, or elect out of installment treatment and pay tax applicable to 2016.
Civics 101
Trump's plans are ambitious, and while Republicans will control the White House and both chambers of Congress, proposed laws have a significant, multi-step gauntlet to survive before they see the light of day. Let's briefly discuss the process by which federal tax laws are made, so you can see through the partisan bickering on which the media will focus and understand the true progress of these proposals in the weeks and months to follow.
Procedurally, legislation begins in the House as a bill, addressed first by the Ways and Means Committee, before being introduced to the full House. The Senate, through its Finance Committee, uses the House version as a starting point but modifies the bill (often substantially) before introducing it to the full Senate. In the rare event that the House version survives the Senate unscathed, it heads to the President. More often, a Conference Committee is formed with members of the House and the Senate to iron out the differences before it advances back through the House and Senate before going to the President. Although the House technically is responsible for initiating the process, it is common for the President to draft proposed legislation and send it to the House via a sponsor to start the process.
Individual income taxation
Rates
There currently are seven individual tax rates ranging from 10% to 39.6%. Trump's plan instead contains three: 12%, 25% and 33%.
The favorable rates provided for long-term capital gains and qualifying dividends will be retained, with such income taxed at 0% for those in the new 12% ordinary income bracket; 15% for those in the 25% bracket, and 20% for those in the 33% bracket.
The alternative minimum tax ("AMT") will be repealed. The 3.8% net investment income tax (which was created to help fund "Obamacare") also will be repealed.
"Carried interest" will no longer qualify for favorable tax rates.
Deductions/credits
While most taxpayers will enjoy lower rates, many will see fewer deductions than currently exist – especially those in the upper brackets. For instance, exemptions will be collapsed into standard deductions, with a combined amount of $15,000 for single filers or $30,000 for joint filers. Head of household status will disappear. Those who opt instead for itemized deductions will see them capped at $100,000 for single filers and $200,000 for joint filers. In exchange for the lower rates, many unnamed deductions are described as "unnecessary or redundant." We are told that charitable contributions and mortgage interest deductions will "remain unchanged for all taxpayers," but it is unclear whether or not these items are subject to the overall cap. Childcare costs will be deductible in arriving at AGI, capped at the average cost of care in the taxpayer's state. This deduction is phased out for single and married taxpayers with incomes of $250,000 or $500,000, respectively.
The Earned Income Credit will be expanded for low-income taxpayers to provide up to $1,200 in rebates toward child care.
Business income taxation
Rates
Let's review current business taxation before discussing how it will change. Oversimplifying a bit, business income today is taxed under one of two regimes: 1. C-corporations and 2. all other businesses, including S-corporations, partnerships, LLCs and sole proprietorships.
- C-corporations currently are taxed at the entity level, at effective rates ranging from 15% to 35%. An alternative minimum tax ("AMT") might instead apply at 20%, using a different income base, but only if higher than the regular tax. In either case, when dividends from those corporations are paid to shareholders, the individual shareholders pay tax (a second tax) on that dividend income – generally at 20%.
- Pass-through entities (S-corporations, partnerships and LLCs) generally are not taxed at the entity level at all. Instead, entity income is deemed to have "passed through" to the owners and is taxed on their returns at whatever rates apply to those owners – even if that income is not actually distributed to them. However, when that entity's income is later distributed to the owners, the owners generally (there are exceptions) do not have to pay a second tax on those "dividends." Sole proprietor income is taxed at the individual level as well.
Trump plans to cut the corporate rate to 15% (down from a top rate of 35%), and eliminate the AMT. However, his plans for pass-through entities ("PTEs") are much less clear. He appears poised to tax all businesses under one regime, regardless of business form, and if so, this represents a very significant change. When contrasting with C-corporations, he notes that "freelancers, sole proprietors, unincorporated small business and pass-through entities are taxed at the high personal income tax rates." For them, he proposes a "new business income tax rate within the personal income tax code that matches the corporate tax rate ..." His website notes that the new 15% rate will be available "to all businesses, both small and large, that want to retain the profits within the business."
Deductions/credits
The rates are not the only aspect of business taxes affected; the President-elect also has plans for a few business deductions and credits.
Significantly, businesses will have a choice – capital investments can be immediately deducted, but only for taxpayers willing to forgo interest expense.
The existing Section 199 Domestic Production Activities Deduction ("DPAD"), which provides an additional 9% deduction for many manufacturing and similar costs, will be retired.
Most business "expenditures" other than the research credit, will be eliminated.
International
Trump's plan calls for a one-time, deemed repatriation of corporate cash held overseas, to be taxed at 10%. Because it is a deemed repatriation, money can be left overseas, but cannot escape the current taxation. Going forward, the same appears to be true, as the plan (without many details) calls for an "end of the deferral of taxes on corporate income earned abroad." The foreign tax credit will survive, however, preventing double-taxation. Collectively, these changes will render corporate inversions (the subject of much press in recent years) nearly useless as a tax-planning move.
Death of the death tax
The Trump plan calls for the end of the federal estate and gift tax. However, an interesting concept takes its place. If an estate's assets include unrealized capital gains of $5 million or more, those gains will be subject to income tax as capital gains at that time. The overall value of the estate will not be a factor in determining taxability; this tax is based on capital gains that have not been taxed during the decedent's life. The campaign also has proposed a ban on contributing appreciated assets to a private family charity to circumvent this capital gain tax.
Conclusion
President-elect Trump, his campaign spokespeople, and most recently his choice for Treasury Secretary, Steven Mnuchin, have described Trump's plan as the largest tax cuts since the Reagan years. With so many deductions on the chopping block, that remains to be seen, but that description seems accurate based on the information available today. House Republicans have developed their own plan and are in ongoing discussions with Trump's team regarding how to reconcile them, but they share many similarities, suggesting that many characteristics described above will appear in the finalized version. If history is a guide, nothing will be complete for several months, but the rules potentially will be retroactive to January 1, 2017. Some unintended consequences and confusing results already seem apparent, and while many of them will be corrected before completion, others will take their places. I'll remind readers again that the proposals described above are nowhere near being finalized, and the related interpretation and analysis involved a murkier-than-usual crystal ball. We will know more in the weeks and months that follow, and will of course update you accordingly. In the meantime, buckle your chinstraps. It should be an interesting ride.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.