The financial world is all abuzz about two main tax reform plans; one proposed by President-elect Trump, and another by the House Republicans. Both call for a massive and revolutionary overhaul of the IRS Tax Code to an extent not seen since the Tax Reform Act of 1986. Some would say the magnitude of the changes afoot will reverberate across the world economy. Indeed, it is hard to overstate how revolutionary these proposals are.
A new tax regime at the Federal level, combined with shifts in domestic policies will inevitably influence taxation at the state and local level as well.
In this article, we will explore the key areas of each proposal – how they are similar, different, and how they compare to our current tax system. We will also look at some proposed and recently enacted legislation that affects state and local taxation of businesses and individuals.
But before we dive into the maelstrom of tax reform, there are a few things worth noting about our upcoming tax season.
2016 Tax Return Items Worth Noting
- Foreign bank account owners – the due date to file your FinCen Form 114 is shortened to the initial due date of your personal tax return, (subject to extensions up to October 15th)
- Electronic filing – The IRS will start accepting returns January 23, 2017
- Filing deadline delayed – The individual income tax return filing deadline is Tuesday, April 18, 2017. This is because the 15th falls on a Saturday, and the following Monday is a holiday in Washington, DC (Emancipation Day), so the deadline is automatically carried forward to the first weekday after.
- Some refunds delayed – Refunds generated in whole or in part by the earned income tax credit or the additional child tax credit will be delayed until mid-February to give the IRS more time to review and detect fraudulent filings.
Now, let us peer into our imperfect crystal ball and see where we are heading along the winding road toward tax reform…
The Tax Overhaul Proposals – In General
Tax cuts at the federal level, for individuals and business are likely to take place – a final bill could come as early as this summer or early fall with most provisions (like lower tax rates) retroactive to January 1st. President-Elect Trump ran on a tax-cut program for businesses and individuals, and has a proposal (the “Trump plan”). The House GOP, in its “Tax Reform Task Force Blueprint” has its own tax-cut proposal (the GOP “Blueprint”).
Whether the tax plans will result in less revenue, more revenue or be revenue neutral depends upon who you ask, and the assumptions they make in arriving at their conclusion. Some would argue that they pick their assumptions to arrive at pre-determined conclusions. Consequently, I choose not to wade into that quagmire.
While tax bills are supposed to originate in the House, the Senate has a say also. It takes 60 votes to pass a bill in the Senate, and currently, among those to serve in Senate after the election, there are not 60 votes to accept either the Trump or the GOP tax plans, so some compromises will likely be required to pass anything.
A process known as “reconciliation” could pass a senate bill with only 52 votes, but those bills are only temporary and must be revenue neutral. Consequently, it is not likely to be utilized unless there is vigorous opposition that would prevent conventional passage of a tax bill.
Both proposals call for wholesale revisions to business taxes and personal taxes.
- Lower corporate tax rates
- The Trump plan calls for lowering the corporate tax rate from 35% to 15%. Some have estimated a $4 Trillion loss in federal revenue over 10 years. If so, it’s not likely to survive congressional tinkering with the rate, unless revenue can be regained in other areas of tax reform.
- The GOP “Blueprint” calls for lowering the corporate rate to 20%.
- The current prevailing wisdom expects a final rate between 25% and 28%.
- Immediate deductions for all capital expenditures except land – both plans call for full deduction of capital expenditures, but in slightly different ways. Under the current rules most capital expenditures must be depreciated over a period of years; the length of time dependent upon the type of asset. For example, if a company invests in a new manufacturing plant at a cost of $1 Million, under the proposals the corporation would get a deduction of $1 Million while under the current system, only a small fraction of that amount would be deductible in the first year, the rest spread out into the future.
- The Trump plans calls for an election to expense capital expenditures, which can be revoked within 3 years of taking the deduction (but each affected year would have to be amended as well).
- The GOP “Blueprint” would make the expensing of capital expenditures automatic, not an election. It would apply to all forms of capital expenditures except land (e.g., equipment, buildings, intangible assets).
- Both plans call for elimination of interest expense – in other words debt and equity financing would be put on equal footing for tax purposes (currently, only dividends are non-deductible).
- This single provision radically alters the tax system from one based on income, to one based on consumption. Expectations are high that this, along with the repatriation rules described below, will lead to a massive influx of investment in the US, creating jobs in the private sector and stimulating growth.
- Update 12-29-2016. The Wall Street Journal reported on December 29th, 2016, that many in the real estate industry are concerned with the impact of these changes, calling the changes ‘radical’. The GOP “Blueprint” does not make any mention of transitional rules for capital acquisitions. Transition rules are “really, really critical” according to Jeffrey DeBoer, president and chief executive of the Real Estate Roundtable, as quoted in the Wall Street Journal article. For example, if a real estate investor financed the purchase of a commercial building in 2016, under the current tax law, they could deduct the interest expense on the loan, and take depreciation deductions over a long period of time. Without any transition rules, the investor would lose the deductions for interest and depreciation starting in 2017, without being able to expense the cost of the property since it was acquired before the tax law takes effect. It is inconceivable to me that there would be no transition rules – it remains to be seen what form those rules will take.
- Alternative Minimum Tax – Both plans call for elimination of the corporate Alternative Minimum Tax.
- Tax Credits and Domestic Production Deductions
- Both proposals call for the elimination of most deductions for domestic production activities and tax credits except for research and development.
- The question arises whether this will put a damper on domestic exploration and production of oil and gas reserves, or will the tax cuts and expensing of capital expenditures be enough to justify the expense of domestic production.
- Net Operating Losses (“NOL’s”) – Currently, if a business’s taxable income is negative, it can elect to “carry back” the loss 2 years, generating refunds for the taxes paid in those years. If the NOL is not completely absorbed by those 2 tax years, whatever is left over can be carried forward for up to 20 years, and applied against future taxable income.
- The Trump plan does not discuss NOL’s
- The GOP “Blueprint” would eliminate NOL carrybacks, but allow NOL carryforwards indefinitely, and limit the use of an NOL to 90% of the taxable income before the NOL deduction.
- It appears that the GOP “Blueprint” adopted this revision to help pay for some of the tax breaks taken elsewhere in their plan.
- Pass-through entities (Sub S corps, partnerships, LLC’s) – Under the current system, “pass-through entities” generally don’t pay any income tax. Instead, the taxable income of those entities is allocated to the owners based on their ownership share of the business, and those owners report their share on their own tax returns. Generally, this pass-through income is taxed at the owner’s personal income tax rate (which can range between 0 and 39.6% for individuals, depending upon their income level).
- The Trump plan says it would apply a 15% tax rate on all businesses, regardless of size, but does not explicitly state whether that applies to the income passed-through to business owners.
- The GOP “Blueprint” calls for a 25% tax rate on active income from a pass-through entity. It also provides that pass-throughs “…will pay or be treated as paying reasonable compensation to its owner-operators…” (emphasis added).
- The pass-through entity would get a deduction for the reasonable compensation, and the owner-operator would report the “reasonable compensation” as wage income, subject to the tax brackets for individuals (i.e., taxed at up to a 33% rate).
- Read “treated as paying” to mean, the IRS will have the power to treat some or all pass-through income as if it was paid in the form of wages, and impose payroll tax liability to the pass-through entity.
- A “reasonable compensation” concept has existed in tax law for a long time, but this proposal is likely to put some teeth into it. However, it’s not clear how “reasonable compensation” will be calculated, and whether it would be imposed across the board, or applied only if the IRS audits the pass-through entity.
- Given that the both plans call for individual income tax rates ranging from 10% to 33% depending upon income level, a person’s wages could be taxed at one rate, while their pass-through income is taxed at another, and their capital gains taxed at yet another rate.
- Repatriation of overseas taxable income – The US is currently the only country that taxes domestic based corporations on their world-wide income, and has the highest corporate income tax rate in the world – 35%. But, world-wide income is taxed in the US only if that income is brought into the US, and is entitled to a tax credit for the foreign taxes paid on that income. Since all jurisdictions outside the US have lower tax rates than the US, there is a net cost for bringing that income into the US. It is no wonder then, that multinational corporations “park” their foreign income abroad. It is estimated that US based companies have over $2.5 Trillion in earnings sitting overseas to avoid being taxed in the US. Of that amount, 30% is held by just 10 companies (Microsoft, Apple, Exxon, and Merck are in the top 10).
- The Trump plan proposes a one-time deemed repatriation tax of 10% on corporate earnings held overseas, payable over 10 years.
- The GOP “Blueprint” would impose a one-time tax of 8.75% on cash, 3.5% on all other earnings, payable over 8 years.
- This is substantially less than the current 35% corporate income tax rate. The theory is that lowering the rates will encourage businesses to re-locate their activities and/or invest in capital in the US from abroad, increasing employment and productivity here at home.
- Taxation of foreign based subsidiaries going forward
- The Trump plan does not address this issue.
- The GOP “Blueprint” would replace the current world-wide taxation scheme
- Distributions and earnings from foreign subsidiaries would be exempt for US tax
- The foreign tax credit would be eliminated
- A new tax scheme on imports and exports of products, services and intangibles (PS&I) would grant a US tax rebate on exports of domestically produced PS&I, and impose a US tax on imported (PS&I). There would be no tax on domestically produced and sold PS&I.
- It is interesting to note that the GOP “Blueprint” says this new corporate tax scheme is designed to be recognized by the World Trade Organization as an “indirect” tax, entitling the US to impose a tax on imported and exported PS&I that had been prohibited under WTO rules under the current US corporate tax system. So, the big question is what happens if the WTO doesn’t think that the final tax bill is an “indirect tax” and insists that we not impose a tax on imports and exports? One would hope that congress (or the State Department) would obtain assurances from the WTO before enactment of a final tax bill. It also begs the question: What if the US imposes taxes on imports anyway? At the very least it could sour relations among our trading partners, possibly lead to trade wars, higher tariffs on US exports, or worse.
- Carried Interest – Under current rules Carried Interest is taxed at lower capital gains rates.
- What is carried interest? According to the Tax Policy Center:
- “Carried interest is a contractual right that entitles the general partner of a private investment fund (often a private equity fund) to share in the fund’s profits. A fund typically uses the carried interest to pass through its net capital gains to the general partner which, in turn, passes the gains on to the investment managers. The managers pay a federal personal income tax on these gains at a rate of 23.8 percent (20 percent tax on net capital gains plus 3.8 percent investment tax).”
- The Trump proposal would tax carried interest at ordinary income rates.
- The GOP “Blueprint” does not address this issue.
- So, what’s all the bruhaha about carried interest? Beats me. A recent article in Forbes, cites estimates by the Joint Committee on Taxation that taxing carried interest at ordinary income rates (rather than the current capital gains rates) would raise $19.6 Billion in revenue over ten years, while the Congressional Budget Office estimates that the total federal revenue over the same period is $14.7 Trillion. Both are huge numbers, but 19.6 billion is 13/10ths of 1% of the total, or 0.1333% of the total! Nowadays it appears that a billion here, and a billion there barely makes a dent in the federal budget, yipes!
- What is carried interest? According to the Tax Policy Center:
- Tax-Free Like Kind Exchanges – The current tax system allows exchanges of property of a like kind on a tax-free basis. For example, one piece of raw land in exchange for another piece of raw land. The rules are so complex, some CPA’s and attorneys have made a living doing nothing but assisting with like-kind exchanges.
- Both plans are silent about whether the current system will remain in place, be modified or eliminated. Some in the industry are fearful that like-kind exchanges will be caught up in the wave of reform and eliminated entirely.
- The real estate industry could be in for a rough adjustment if these provisions are eliminated.
- Tax brackets: Both plans call for only 3 tax brackets with rates based on taxable income. The chart below compares current law with the two plans for Married Filing Joint
|2016: Married||Trump Plan: Married||GOP Blueprint: Married|
|10-15% up to $75,300||12% up to $75,000||0%/12% *|
|25%, 28% up to $231,450||25% up to $225,000||25% *|
|33%, 35% & 39.6%
- * The GOP “Blueprint” doesn’t describe the taxable income levels, only the rates.
- Capital Gains
- The Trump plan
- Would leave the tax on capital gains as it is today – 0%, 15% or 20% depending upon your income level.
- The 3.8% tax on net investment income under the Affordable Care Act would be repealed.
- GOP “Blueprint”
- Calls for tax on only ½ of capital gains, dividends and interest income, at current cap gain rates, “…leading to basic rates of 6%, 12.5% and 16.5%…” depending upon your income level.
- The Trump plan
- Standard Deduction, Personal Exemptions, and Itemized Deductions – it would be easy to see if you are better off with these new tax plans if lower tax rates are the only changes being considered. Unfortunately, the proposals also tinker with the Standard Deduction, Personal Exemptions and Itemized Deductions.
- Both the Trump plan and the GOP “Blueprint” call for an increase in the standard deduction and child tax credit (good) in exchange for complete elimination of personal exemptions (not so good).
|Item||Current – Married/Single||Trump Plan – Married/Single||GOP Plan – Married/Single w/ child|
|Personal Exemptions||$4,050 per person||-0-||-0-|
|Itemized Deduction||Phased out based on income level||Capped at $200,000/$100,000||Only home mortgage interest and charitable contributions allowed – all other itemized deductions eliminated|
|Child Credit||$1,000 per child||*||$1,500 per child|
* The Trump plan has a complex system of deductions, integration into the Earned Income Tax Credit and creation of Dependent Care Savings Accounts. It does not mention any other child tax credit.
Every family’s income tax calculation is different, so it remains to be seen if your tax burden will go down, or up.
Large, low income families may be adversely affected by these changes to the point where some may have a tax increase. That is because the $4,050 exemption for each person in a family is a larger percentage of taxable income when income is low, compared to taxable income when income is large.
Put it another way, for married filing joint taxpayers, under the Trump plan the standard deduction is increased by $17,400 in exchange for elimination of personal exemptions – that increase is equivalent to 4.3 personal exemptions ($17,400/$4,050); a family of 5 or more would be negatively impacted. Under the GOP “Blueprint”, the standard deduction is increased by $11,400 or 2.8 personal exemption amounts; a family of 3 or more would be negatively impacted. Some of that negative impact is offset by lower tax rates, but in the lower income brackets that offset may not be enough to compensate, resulting in a slight tax increase.
- GOP “Blueprint” Post-Card Tax Return – The GOP “Blueprint” borrowed from a campaign pledge by Senator Ted Cruz to provide a tax return the size of a post-card. Here it is:
- The Estate Tax (aka the “Death Tax”) – For 2016, estates worth more than $5.45 Million are subject to an estate tax, so for a large portion of the population, the estate tax is nothing to worry about. For those who have taxable estates, the tax rates can be as high as 40%.
- Both the Trump plan the GOP “Blueprint” call for elimination of the Estate Tax.
- This tax generates over $200 Billion in revenue each year ($2 Trillion over 10 years), so it is unlikely to be eliminated entirely. However, recent regulations that work against family limited partnerships for estate planning are expected to be thrown out.
- Gift and Generation-skipping transfer tax – Under the current tax structure, these taxes work in tandem with Estate Taxes. You can make gifts tax free each year if they fall under a set annual threshold per donee, but if you exceed that threshold, it reduces the $5.25 Million threshold at which estate taxes kick in after you die.
- Neither of the plans are clear on their approach to these taxes.
- The Trump plan is unclear as to both.
- The GOP “Blueprint” would repeal the generation-skipping transfer tax, but is unclear about the gift tax.
- “Step-Up” in basis, Tax on Unrealized Appreciation
- Current law allows for a step-up in basis on inherited property. For example, let’s say Betty inherits a house with a fair market value (“FMV”) of $500,000 from her last surviving parent who has a “basis” in the house of $100,000 (generally, the “tax basis” in an asset is the original cost plus costs of improvements, minus any depreciation deductions taken on it). There is an unrealized gain in the house of $400,000 ($500,000 FMV minus $100,000 cost). Betty gets to treat the house for tax purposes as if she paid $500,000, for it; that is, she receives a “step-up” in basis to the current FMV of the house, completely tax free.
- The Trump plan
- Would eliminate the step-up in basis. Continuing the example above, assume a few years go by the house increases in value and Betty sells it for $700,000. Under current law Betty would have a gain of $200,000 ($700,000 sales price minus her stepped-up basis of $500,000), but under the Trump plan Betty would have to report a gain of $600,000 on the sale ($700,000 sales price minus inherited basis of $100,000).
- In addition, the Trump plan would tax any unrealized gain on capital gain property over $10 Million at the time of death of the owner. Clearly, this is an increase in tax that only applies to the wealthiest 1% in this country.
- The GOP “Blueprint” is unclear on both issues.
References – If you would like to read more about these tax reform proposals you can find them through the following links:
State and Local Taxes
There is a mixed bag of good and bad news for individuals and businesses when it comes to proposed and enacted changes to state and local taxes.
- Federal Grants to Local Government – 30% of state and local budgets are funded by grants from the federal government. Some fear that federal grants may be curtailed to help fund the tax cuts, so state and local governments may be looking for ways to make up for any shortfalls. This could take the form of:
- Higher sales and property tax rates;
- Eliminating some exemptions and discounts from taxation; and
- Expanding sales taxes to out-of-state retailers who sell in-state.
- Texas Franchise Tax – The Texas legislature will convene in 2017, and the conventional wisdom has been that the Franchise Tax rate on businesses will likely be lowered.
- Given the turn of events in the general election, and the fear of curtailed federal grants to the states, this idea may not be as popular as it was before the election.
- On the flip side, President-Elect Trump has named prominent Texans to important cabinet posts. Some Republicans in Texas feel that their state had been treated unfairly by the Obama administration for opposing some of its policies, legislation and executive orders. They feel that Texas is due some pay back; perhaps federal grants, may not be cut back as much as other states. If that happens, it improves the chances for a lowering of the Franchise Tax rate.
- Pending legislation – Sales Tax Simplification Act – a federal bill to benefit the states, it would overturn a decades-old US Supreme Court case, Quill vs Heitkamp, 504 US 298 (1992).
- Quill held that a retailer had to have a physical presence in a state before that state could impose sales tax on sales into that state. It is important to note that the Quill opinion said Congress has the right to overturn this case through legislation.
- The Sales Tax Simplification Act would do just that, clearing the way for states to collect sales taxes on all interstate sales even to states where the seller had no physical presence.
- Republican Senator Mitch McConnell (who appears to have the ear of President-elect Trump) has promised action on other forms of this legislation. Opponents say this bill and others like it violates the concepts of federalism, increases incentives for states to raise their sales tax rates, and results in “taxation without representation” – a concept more than just frowned upon by our founding fathers (think Boston Tea Party).
- If you are an online retailer or sell remotely to any state – if you sell your products online, or to states where you have no physical presence, pay close attention. There are good points and bad points for retailers:
- Good points –
- It creates a clearing house for all sales taxes collected.
- You determine what is taxable by your state’s rules (no more trying to figure out each state’s sales tax rules), but charge the sales tax rate of the state of your buyer.
- One sales tax rate for each state (currently there are over 12,000 separate sales tax jurisdictions in the US, all with their own rates, so this is a BIG simplification).
- Sellers remit the sales taxes they collect to their state, and that state is responsible for disbursing to the other states, not the seller.
- Expect to see software developers create systems to automatically collect the right amount of tax based on the buyer’s location information.
- Your business would only be subject to a sales tax audit from your home state.
- Bad points –
- If you haven’t been collecting sales tax on out-of-state sales, you will if this law is passed.
- Under the bill, each state would have the option to opt-in or opt-out of the clearinghouse; those that opt-out will be under current rules – no tax simplification for sellers into those states.
- Sellers must know the sales tax rates of each state opting in (still, its simpler than what happens now).
- There does not appear to be any exemption from this law, regardless of whether you make 1 sale or 1 Million sales to a particular state, you still must collect the tax on each sale.
- Complicated rules if you sell from one of the 5 states that don’t have a sales tax, or if you are selling from outside the US into the US.
- Good points –
- If you are a consumer – There are good and bad points to this for consumers:
- Good points –
- If you live in a jurisdiction that has add-on taxes from local jurisdictions (e.g., purchasers of goods in Harris County pay a state and county sales tax) you may end up paying a lower sales tax for on-line and out-of-state purchases (but that remains to be seen, the bill allows the states to set their own rates for these purposes).
- What is subject to sales tax in your state, may be exempt in another (e.g., textbooks or groceries), so you could “shop around” for a retailer located in a state that exempts the product you are buying and not pay any sales tax on it.
- Bad point –
- If you buy online from retailers who don’t currently collect sales tax, this law will change that.
- Good points –
- Recent Colorado legislation could be adopted in your state –
- The 10th Circuit Court of Appeals upheld a recent Colorado law requiring all retailers without a physical presence in the state, to report their customers’ names and total sales. The court reasoned that it doesn’t violate the holding in Quill because this statute only required reporting of information, not collection of taxes. Some fear that Colorado could possibly use this information to collect “use tax” from the purchasers, though it would be problematical without knowing their addresses, and would be extremely unpopular among the masses.
- On December 12, 2016, the US Supreme Court refused to hear an appeal of the 10th Circuit’s ruling, having the practical effect of upholding that law.
- If the Sales Tax Simplification Act goes into effect, this kind of legislation may only appeal to states that opt out of the state sales tax clearinghouse.
- Pending Legislation – Mobile Workforce Bill – Another federal bill, this legislation would prohibit states from enforcing state income tax withholding on employees who conduct even the smallest amount of activity in their state. This prohibition on withholding state income tax would not apply to employees who are residents of that state or who spend over 30 calendar days on business in that state.
- Public vs Private Education – President-Elect Trump has proposed Betsy DeVoss as Education Secretary.
- DeVoss has been an influential champion of charter schools, school choice, voucher programs for private schools, and other areas of education reform. This increases the chances of a regulatory shift to encourage expansion of charter schools and voucher programs.
- This appointment, combined with the fact that Republican majorities exists in many state legislatures and governorships, increases the chances of state legislation implementing these kinds of reforms. Basically, it’s a way for property owners to get a discount on their property taxes if they are sending their children to private schools. According to the Foundation for Excellence in Education, (of which Ms. DeVos was a member of the Board of Directors in 2015), there are at least 23 states that have adopted legislation supporting school choice.
- On the flip side, this means a reduction in revenue for public schools. Proponents of reform say this will increase competition and raise the education standards of public schools to compete for students. Opponents say it’s a subsidy for private schools at the expense of the public school system, and that lower revenue will result in lower education standards in public schools.
- Regardless of which side you are on, keep your eye on the school bond market. I would expect the value of existing school bonds to drop, and make it harder to find investors in any new bond issues.
- Even more interesting is the possibility of private schools pooling together to issue their own bonds to raise revenue. Large private school systems, like Catholic schools could possibly float a bond issuance at the Diocesan level. It is unclear if there are any legal restrictions on this activity, and whether interest on such bonds would be considered taxable or tax exempt at the Federal level.
There is an old Chinese curse, “May you live in interesting times.” Whether you consider the proposed changes to our federal and state tax systems a curse or a blessing, it’s going to be interesting to see how it all shakes out.
I’m Ed, and I’m just sayin’…