President-Elect Trump and Possible Tax Law Changes
The election season “like no other” ended with a result that most polls and pundits failed to predict: Donald Trump as our 45th president. As that surprise starts to fade, questions commence on what to expect from a Trump presidency. Because our focus is taxes, we will address possible changes on that front – understanding that this currently involves trying to read the tea leaves, including Mr. Trump’s campaign website, the House Republican blueprint for tax reform called A Better Way, and the “Death Tax Repeal Act of 2015” (H.R. 1105). We’ll start with Mr. Trump’s website.
Income Tax – Individuals. Our current system has seven rate brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. The Trump proposal would collapse these into three, as follows:
- 12% for taxable income under $75,000
- 25% for taxable income from $75,000 but less than $225,000 and
- 33% for taxable income in excess of $225,000
Comment. These brackets would apply to married couples filing jointly (single filers would be subject to half these amounts). By way of comparison, in 2016, married couples filing jointly are subject to the current 33% bracket at taxable income over $231,450, the 35% bracket at taxable income over $413,350, and the 39.6% bracket at taxable income over $466,950.
The existing capital gains rate structure would remain, with its maximum rate of 20%; “carried interest,” which managers of hedge funds and private equity funds typically receive, would be taxed at ordinary income tax rates rather than capital gains tax rates, which currently apply.
The following items would be repealed or replaced:
- The 3.8% net investment income tax.
Comment. This tax commenced in 2013 under the Affordable Care Act (a/k/a “Obamacare”), and is a surcharge on net investment income (such as capital gains, dividends and royalties); it can apply if a taxpayer’s income exceeds certain threshold amounts that are not indexed for inflation (e.g., $250,000 for married filing jointly).
- The alternative minimum tax (AMT).
Comment. This is a parallel tax system that reaches deep into the middle class and is designed to ensure that taxpayers pay “enough” tax; the AMT adds back various items that can reduce a taxpayer’s “regular” tax, such as itemized deductions for state and local taxes. If a taxpayer’s AMT exceeds the taxpayer’s regular tax, the taxpayer pays the higher amount.
- Personal exemptions and the “head of household” filing status.
Comment. In 2016, the personal exemption is $4,050, and is available for the taxpayer, the taxpayer’s spouse and the taxpayer’s dependents, such as minor children. Nevertheless, these exemptions are phased out (and eliminated) if the taxpayer has “too much” income; they also do not count against the AMT. “Head of household” status applies to single parents with, say, dependent children, and provides more favorable tax brackets than the “single” taxpayer status. Both items – the personal exemption and head of household – would be replaced by a larger standard deduction ($30,000 for married filing jointly, and $15,000 for single taxpayers).
Other changes would include:
- Itemized deductions would be capped at $200,000 (married filing jointly) or $100,000 (single filers). (These deductions currently include payments for items such as mortgage interest, state and local taxes and charitable contributions.)
- Married taxpayers with income up to $500,000 ($250,000 for single taxpayers) could take an “above-the line” deduction for children under age 13 (capped at a state average), limited to four children per taxpayer. There also would be a similar deduction for an elderly dependent, capped at $5,000 per year (indexed for inflation).
- Spending rebates for childcare expenses would be available for certain low-income taxpayers through the Earned Income Tax Credit. The rebate would equal 7.65% of remaining eligible childcare expenses, subject to a cap of half the payroll taxes paid by the taxpayer. This rebate would be available to married joint filers earning $62,400 ($31,200 for single taxpayers).
- Taxpayers could establish Dependent Care Savings Accounts for specific individuals, including unborn children, up to $2,000 per year from all sources (e.g., parents, grandparents, employers). If established for children, rather than dependent elders, funds still in the account when the child reaches age 18 could be used for educational expenses, but additional contributions could not be made. For low-income taxpayers, the government would provide a 50% match on parental contributions of up to $1,000 per year.
Estate Tax. The website states that the “Trump plan will repeal the death tax, but capital gains held until death will be subject to tax, with the first $10 million tax-free as under current law to exempt small businesses and family farms. To prevent abuse, contributions of appreciated assets into a private charity established by the decedent or the decedent’s relatives will be disallowed.”
Comment. Although the estate tax would be eliminated, there would be a capital gains tax at death for appreciated assets in excess of $10 million. It is unclear whether this amount applies per person, or per married couple. In addition, the proposal is silent on the fate of the gift tax, as well as the generation skipping transfer tax, which applies to transfers, either outright or in trust, to people such as grandchildren. Finally, it appears that gifts of appreciated property to a private foundation created by the decedent or the decedent’s family would be subject to capital gains tax at death, although gifts to someone else’s private foundation or to a public charity apparently would not trigger capital gains tax.
Business Tax. The business tax rate would drop from 35% to 15%, and the corporate alternative minimum tax would be eliminated. Off-shore corporate profits could be repatriated at a one-time rate of 10%. Most corporate tax “expenditures” (i.e., tax benefits that reduce taxable income, such as credits) would be eliminated, except for the Research and Development credit. Firms manufacturing products in the United States could elect to “expense” their capital investment and lose the deductibility of corporate interest expense (this is similar to some of the corporate tax suggestions in A Better Way – see below).
A Better Way
House Republicans released A Better Way - Our Vision for a Confident America on June 24, 2016. This 35- page document is a blueprint for “bold, pro-growth” tax reform. It states that our tax code and the IRS are broken (it would restructure both), and that the tax code imposes “burdensome paperwork and compliance costs, delivers special interest subsidies and crony capitalism, penalizes savings and investment, and encourages businesses to move overseas.” A Better Way (ABW) thus advocates for a tax system that is “simpler, fairer and flatter,” with reduced tax rates in exchange for a broader tax base. Reform would be “revenue neutral” and bring in the same amount of revenue, taking account of anticipated economic growth. Translated, this means that the new system would significantly reshuffle the deck, and presumably result in the loss of cherished tax benefits for some, but the advent of welcome changes for others. Here is some of what ABW proposes:
Income Tax – Individuals. ABW would collapse the current seven rate brackets into the same three as Mr. Trump: 12%, 25% and 33%. It would also:
- Eliminate the AMT (see above).
- Eliminate the various taxes associated with “Obamacare,” for which repeal is assumed. (These include the 3.8% net investment income tax, the additional 0.90% Medicare tax on income above a threshold amount (e.g., $250,000 for married filing jointly), the 2.3% medical device tax, and the 40% excise tax on so-called “Cadillac” plans (now scheduled to go into effect in 2020, rather than 2018).)
- Permit individuals to deduct up to 50% of their net capital gains, dividends and interest income – which would make for a maximum tax rate of 16.5% on such income (note that under current law, interest income is typically taxed as ordinary income, rather than at favorable capital gains tax rates).
- Consolidate various family benefits, such as personal exemptions and the child tax credit into a larger standard deduction and enhanced child and dependent tax credit.
- Eliminate itemized deductions except for mortgage interest and charitable contributions (taxpayers could use the larger standard deduction OR these two deductions).
- Simplify and consolidate higher education tax benefits (this would include a savings incentive, such as 529 plans).
- Have taxable employee “compensation” match the “compensation” employers may deduct (this could make employer-provided health care taxable, although this issue would be addressed by a separate task force).
- Consolidate and reform the various retirement savings provisions.
Estate Tax. ABW would repeal the estate tax and the generation-skipping transfer tax. It is silent about the gift tax, and whether the current basis adjustment rules would remain (these eliminate a decedent’s built-in capital gains AND losses) or would be replaced by a capital gains tax at death for a decedent’s appreciated assets or some kind of carryover basis regime, whereby heirs effectively “inherit” a decedent’s built-in capital gains and losses.
Business Tax. There would be a new business tax rate for small businesses organized as sole proprietorships and for pass-through entities (such as partnerships, S corporations or limited liability companies). The maximum tax rate would be 25%, rather than the proposed top rate of 33% for individuals. For large businesses operated through C corporations, which are currently subject to a corporate tax rate of 35%, ABW would lower the corporate tax rate to a flat 20%, while eliminating the corporate alternative minimum tax. In addition, ABW would allow the immediate write-off of business investments (what’s known as “expensing”). Interest expenses could be deducted against interest income, but no current deduction would be allowed for “net interest expense”; this would eliminate “a tax-based incentive for businesses to increase their debt load beyond the amount dictated by normal business conditions.” In general, “special-interest deductions and credits” would disappear, in favor of lower rates for businesses and not taxing business investment, so that business decisions would be based on “economic potential rather than…targeted tax benefits” (the Research and Development credit would be retained). ABW would also move away from a worldwide approach to taxing corporate profits in favor of a more “territorial” approach, whereby tax jurisdiction follows where a product is consumed rather than where it is made.
The Death Tax Repeal Act of 2015 (H.R. 1105)
In early 2015, Rep. Kevin Brady (R-TX), Chairman of the House Ways and Means Committee, introduced “The Death Tax Repeal Act of 2015” (H.R. 1105) in the House. The bill had 135 co-sponsors: one Democrat and 134 Republicans. On April 16, 2015, the House passed the bill (240 to 179); the following week, it was introduced in the Senate, where no further action has been taken on it.
The bill repeals the estate tax and the generation-skipping transfer tax (GST), while retaining the gift tax in a somewhat modified form: there would be a $5 million gift tax exclusion, indexed for inflation, and a top rate of 35%; transfers in trust would be treated as gifts unless the grantor or the grantor’s spouse was responsible for paying the trust’s income taxes (what’s known as a “grantor trust”). For ten years after the bill’s enactment, qualified domestic trusts (QDOTs) would continue to be subject to estate tax (a QDOT is a trust for a non-citizen surviving spouse; it postpones estate tax at the deceased spouse’s death but triggers estate tax if principal distributions, other than those necessitated by hardship, are made to the surviving spouse). The Joint Committee on Taxation estimated that the bill would cost $269 billion over 10 years.
The Death Tax Repeal Act of 2015 essentially mirrors the legislation that repealed the estate tax and GST in 2010 (but just for that year), with one major difference: it does not have the “modified carryover basis” provisions that allowed a limited basis step-up of $1.3 million for the decedent’s appreciated property, with an additional $3 million step-up for appreciated property passing to a surviving spouse. In other words, although the Death Tax Repeal Act of 2015 would repeal the estate tax and GST, it preserves the existing basis adjustment rules, so that the decedent’s built-in capital gains (and losses) would be eliminated at death.
Comments. The above discussion reflects possible tax law changes. Yet until there is draft legislation, no one really knows what it will say or do. And several factors make tax reform especially challenging: cost and constituencies. As those close to the tax legislative process often observe, “There are budget constraints.” Independent budget watchdogs have estimated that Mr. Trump’s proposals could run some $3-$6 trillion over ten years, notwithstanding his assurance of economic growth. Such a number, if accurate, could add significantly to the deficit, and potentially entail cuts to entitlement programs to help pay for it – even though Mr. Trump has said he does not want to cut Medicare or Social Security benefits.
A Better Way’s promise of revenue-neutral tax reform means that in exchange for lower rates, various tax benefits would be on the chopping block, such as the deduction for state and local income taxes and the current tax-free status of employer-provided health care. This is where constituencies come into play: for every such benefit, there is an attentive and insistent “someone” who pays close attention to the continued longevity of that coveted benefit, and presumably will fight hard to preserve it.
As for the estate tax, it is a true “hot button” item. When the Death Tax Repeal Act of 2015 passed the House, there was intense rhetoric from both sides of the aisle, with Republicans insisting that the estate tax was immoral and unfair, and that repeal was needed to save family farms and ranches; Democrats just as insistently maintained that the estate tax affects less than 1% of the population, and that its repeal would be a costly give-away to the wealthy, at nearly 1/3 of a trillion dollars over ten years. (It goes without saying, of course, that President-elect Trump would benefit greatly from repeal.)
To Sum Up. What will happen? Considering that there is a highly motivated Republican trifecta – an incoming Republican president and a Republican-controlled House and Senate – tax reform seems likely to take off in the new 115th Congress. Although there is room for bipartisan agreement in certain areas, such as the need to repatriate offshore corporate earnings, what to do with those potential tax revenues differs: Republicans would like to use those dollars to reduce the corporate tax rate, while Democrats would like to put them towards infrastructure projects. There is also disagreement on how to address the individual income tax. And while Republicans could use “reconciliation” to pass tax reform legislation in the Senate, thereby only requiring 51 votes (as opposed to 60), reconciliation has a poison pill: provisions that would adversely affect revenues beyond the related 10-year budget window can only have a 10-year shelf life (thus, the “sunset” that was part of the 2001 Bush tax cuts).
P.S. End of Year Actions? Given what appears to be a high probability for reduced taxes within the next year (or two), what might taxpayers consider doing between now and year end? Defer income, to the extent possible, while accelerating deductions that might otherwise be limited or disappear under various reform scenarios. In other words, for example, it may make sense to accelerate charitable contributions, as those deductions may be limited, just as it may make sense to prepay estimated state and local tax, as that deduction may disappear – understanding, however, that this deduction is an “add-back” for AMT purposes and can exacerbate a taxpayer’s potential exposure to that tax.
P.P.S Curtains for the Proposed 2704 Discount Regulations?
On August 2nd, the IRS released proposed regulations dealing with valuation discounts that taxpayers have successfully used to transfer interests in family-controlled entities to family members. (See the 8/31/16 and 9/30/16 editions of Tax Topics for more on these regs.) The regulations have been criticized from many quarters as harmful to small businesses. Most recently, on November 3rd, the Republican members of the House Ways and Means Committee wrote to Treasury Secretary Jacob Lew urging that the regulations be withdrawn, as they are “not consistent with congressional intent”; the letter also states that any “new proposal in this area should be clearly defined and narrowly targeted within the reach of the applicable statutory rules.” Given all of this expressed hostility and the clear pro-growth and pro-business slant of the incoming Congress and President, it seems doubtful that these regs will be finalized in their current form – if indeed they are finalized at all. Taxpayers worried about the impact of these proposed regs on existing or imminent planning therefore appear to have gotten a reprieve (at least for the moment).
December 7520 Rate
The IRS has issued the December 2016 applicable federal rates: the December 7520 rate is 1.8%, an increase of 0.20% (20 basis points) from November’s 7520 rate of 1.6%. The December mid-term rates are also up: 1.47% (annual) and 1.46% (semiannual, quarterly and monthly). The November mid-term rates were: 1.33% (annual, semiannual, quarterly and monthly)
**This article was posted with the permission of Blanch Lark Christerson.
Blanche Lark Christerson is a managing director at Deutsche Bank Wealth Management in New York City, and can be reached at firstname.lastname@example.org.