When I was a Boy Scout, we jokingly sang a song any time one of our colleagues made us wait. It started with "Here we sit like birds in the wilderness," and ended with our group announcing for whom we were waiting. I think it may be time for us to sing this song to Congress, though you may want to sing it in your head for fear of people questioning your sanity.
After nearly 200 days in office with the new administration, we've heard members of Congress express interest in a wide range of tax reform ideas, including the so-called "Border Adjustment Tax", elimination of some or all itemized deductions, increase in earned income tax credit, and creation of a territorial tax system. These ideas have been supplemented by Donald Trump's tax plan, which I analyzed in a post nearly a month ago.
Despite the multitude of ideas, there have been no concrete proposals, votes, or perhaps most importantly, legislation advanced. Though we may not enjoy it, tax reform is an intricate and difficult process that always takes longer than we expect. With this in mind, let's explore some of the ideas recently expressed by House Republicans, with a focus on how the ideas would affect our current and potential clients.
The House Republican Tax Plan
On June 24, 2016, the House Republicans released a "Better Way for Tax Reform," available in full here. Although it isn't the most fascinating read (there's certainly a bit of fluff and a few contrived examples in the plan), the plan contains a number of proposals that could drastically affect the way individuals and small businesses are taxed, including:
- Elimination of the corporate and personal Alternative Minimum Tax
- Elimination of all itemized deductions, except for mortgage interest and charitable contributions
- Elimination of most personal credits
- Elimination of the Estate and Generation Skipping Transfer Tax
- Changing the way interest, dividends, and capital gains are taxed
- Allowing full expensing of capital expenditures
- Disallowing interest deductions on new loans
- Border adjusting business taxes*
- Eliminating the Domestic Production Activities Deduction (DPAD) and all business credits
- Expanding and consolidating the standard deduction
- Changing the tax brackets
- Taxing income from passthrough businesses at a maximum rate of 25%
- Lowering the corporate income tax rate to 20%
- Changing to a territorial tax system
As you can tell, the House Republicans are shooting for a laundry list of changes. With any proposed legislation, it is possible that a number of these ideas will be substituted for others or nixed altogether. You will notice that I've put an asterisk next to the infamous border adjustment tax. Based upon the most current information available, it appears as though border adjustment taxes are unpopular enough to render their proposal dead on arrival. Though it has not been explicitly stated, it would not be hard to believe that there are other dead on arrival ideas lurking in the plan.
Repealing the alternative minimum tax - yes, sign me up! This has been a staple of Republican ideology for a number of years, and it is a fantastic idea. Most high net worth individuals know of the alternative minimum tax, but few can define it. Other than that it's bad.
You can think of the alternative minimum tax as a different way of explaining taxable income. For regular tax purposes, taxpayers are allowed numerous deductions and credits. For alternative minimum tax purposes, taxable income starts with federal adjusted gross income minus itemized deductions. To that, a taxpayer's state, local, and real estate tax deductions are added back, along with investment expenses, tax planning fees, and a number of other deductions. For AMT, you aren't allowed personal exemptions, either.
The practical effect to eliminating the alternative minimum tax is tax compliance simplification. With no alternative minimum tax, business owners will no longer have to keep separate depreciation and basis schedules for fixed assets and investments. With simplified reporting, taxpayers could see lower costs of compliance, too.
High income taxpayers currently subject to AMT may not notice a decreased tax bill at the end of the year by virtue of repealing the AMT, however. Under the House Republican plan, itemized deductions would consist of charitable contributions and mortgage interest. Presumably, that means deductions for investment management fees, interest expense from investing activities, real estate taxes, and state/local taxes will be eliminated**. While this may not seem like a big deal - after all, taxpayers subject to AMT aren't allowed deductions for these items anyway - it is the difference in tax rates that causes a problem. Currently, taxpayers subject to AMT pay a maximum rate of 28% on their alternative minimum taxable income. Everything else remaining the same, those same taxpayers would pay a maximum rate of 33% under the new House Republican plan. Without any clarification, these same taxpayers could also lose their carryover credit for prior year AMT. Ouch!
The House Republican plan isn't all bad news for high net worth individuals, though. An interesting proposal in the blueprint is to change the way intangible income is taxed. Currently, taxpayers are subject to a maximum tax rate of 23.8% on long term capital gain and qualified dividend income, while short term capital gain and interest income is taxed at ordinary rates, for a maximum rate of 43.4%. Read this next sentence very, very carefully: the House Republican plan proposes taxing interest, dividends, and capital gains at new ordinary tax rates, but only after allowing a deduction for 50% of the net interest, dividends, and capital gains.
If you have significant intangible income or are considering selling a business, this proposal should make your ears perk up. Rather than being taxed at 23.8% or 43.4%, all of your intangible income will be taxed at a maximum rate of 16.5%. That's a big deal.
What about business owners?
Small business owners should be cautiously optimistic about the House Republican tax plan. I say cautiously optimistic not just because the plan will undoubtedly go through numerous changes, but also because the plan itself is ambiguous in certain cases.
Take, for example, the proposal to tax passthrough income at a maximum rate of 25%. The idea behind this proposal is to allow S corporations, partnerships, and sole proprietorships to compete with C corporations, which would be taxed at a maximum rate of 20%. In theory, this is a good idea, but the following quote is somewhat ambiguous: "Under this new approach for taxing small businesses, sole proprietorships and passthrough businesses will pay or be treated as having paid reasonable compensation to their owner-operators. Such compensation will be deductible by the business and will be subject to tax at the graduated rates for families and individuals."
Now this doesn't make a whole lot of sense. For a tax plan that's designed to create tax code simplicity, adding payroll to a sole proprietorship or partnership seems to miss the mark, because payroll processing increases the cost and complexity of complying with tax law. Furthermore, this proposal could affect the way certain individuals calculate retirement plan contributions. For individuals receiving directors fees and relying on the self-employment income generated to fund retirement plans, we are not sure whether this new payroll requirement would reduce a taxpayer's self-employment income and thereby reduce the allowable retirement plan contribution. We're not quite sure how one would define a reasonable wage for an individual receiving director's fees, either.
From a tax prospective, this proposal could be a boon for small business owners, though. Though this too is ambiguous, the proposal seems to suggest that small business income, by way of being segregated into wages and business profits, would go through the lower rate brackets twice. Therefore, the business owner's business profits would be taxed at lower rates, presumably beginning at 0%, to a maximum rate of 25%, and their wages would be taxed separately starting at 0%, to a maximum of 33%. This segregation of tax brackets could increase complexity, but hey, you can't argue against lower tax bills for hard working, job creating small business owners.
Also on the list of proposed changes is a hotly debated twofer - allowing full expensing of capital expenditures while disallowing net interest deductions for new loans. The idea behind this proposal is to reduce debt fueled investment into tangible and intangible business assets, but I am not sure it will accomplish that goal. This is another source of ambiguity - sure, I would not be jumping for joy as a business owner if I wasn't allowed an interest deduction for a loan, but if I could purchase a piece of machinery using low cost debt and expense the full value in the year I purchase it, I'm not sure I would much care about the disallowed interest deductions. It certainly would not stop me from purchasing assets using debt. If, on the other hand, the proposal would only allow full expensing of assets purchased with cash, the goal may be achieved and small business owners relying on leverage would be disappointed.
It is important to note that the proposal allows interest deductions to the extent of interest income, and all disallowed interest expense would carry forward indefinitely. If the deduction is disallowed at the personal level versus the corporate level, owners of passthrough entities with significant investment interest income (e.g. fixed income investments) could still benefit from interest deductions.
The elimination of the Domestic Production Activities Deduction (DPAD) is not an unexpected proposal. Though the elimination of deductions would likely be offset by lower tax rates, it could be a good idea to continue encouraging domestic production by allowing some sort of deduction for qualified activities. The good news is that this proposal does not appear to change IC-DISC rules; for manufacturing companies whose products ultimately end up overseas, an IC-DISC could still be a viable option, because it allows the owner to turn ordinary income into dividend income. Under the House Republican plan, the savings would not be as significant (25% to 16.5% versus 39.6% to 23.8%), but it would still be worthwhile to analyze.
But what about repealing the estate tax?
The estate tax, as I said when analyzing Donald Trump's plan, provides for a very, very small portion of our country's tax receipts. Elimination of the estate tax would simplify estate planning for high net worth individuals. But I would not go so far as to stop talking to your estate planning attorney if this proposal becomes law.
The estate tax is goofy. Essentially, the government says, "look, you were very successful during your lifetime. We are very happy for you, and though we have taxed every dollar you've made along the way and invested thereafter, we're going to take 40% of everything you have over a certain amount anyway." Though it does not seem particularly fair, one has to realize its motives are more focused on politics than generating revenue. Because demonizing successful business owners and investors draws politicians more votes, it is likely that even if the estate tax is repealed, it won't be repealed for long. Ergo, keep talking to your estate planning attorney but try not to pay any gift tax in the meantime if at all possible.
**Given planning, certain deductions may not be completely eliminated.
If you are interested in discussing the possible implications of tax reform at greater length or making a comprehensive plan to decrease your tax liability, drop me a line at firstname.lastname@example.org or give me a call at 513-554-4600. If you would like to read the Tax Foundation's analysis of the budgetary effects of the House Republican plan, please do so here.