On Thursday, November 2, 2017, the House Ways and Means Committee revealed its 429-page “simplification” of the Internal Revenue Code (“Code”). This article will attempt to summarize the proposed bill and we will follow up from time to time to as the bill winds its way through Congress.
First a warning: If history is any guide, there will be numerous changes and compromises along the way, so one should be careful about making any major moves based on these proposals. History dictates that it’s better to watch and wait to see how the dust settles, but keeping up on the basic changes is good preparation for that day.
On the individual front, the proposal eliminates itemized personal deductions, except for charitable donations, property taxes (though limited, as discussed below) and the residential mortgage interest deduction. Only the interest on mortgages of up to $500,000 (down from $1,000,000) will be deductible and it will be available only for primary residences. The proposal nearly doubles the standard deduction to $12,000 ($24,000 for married couples) and eliminates personal exemptions as well as itemized deductions. The elimination of itemized deductions will hit residents of certain states like NY very hard because it will eliminate deductions for state and local taxes. However, the plan does add increase the family tax credit from $1,000 to $1,600 for a qualifying child and a $300 tax credit for any other dependent who is not a qualifying child. Oddly, the $300 tax credit would be eliminated in five years.
Initially, Trump’s proposal eliminated the deduction for local property taxes. However, this new plan caps property tax deductions to $10,000. It is also important to note that the plan completely proposes eliminating medical expense deduction. Currently, to deduct medical expenses, the expenses must be in excess of 10% of adjusted gross income. This proposal would eliminate all medical expense deductions, including those substantial expense deductions for older taxpayers who are in nursing homes or similar facilities. Gone are also deductions for student loan interest. Currently, there exists $1.3 trillion in student loan debt. The elimination of the interest on that debt would disproportionately affect the middle class.
The plan also reduces the current seven income tax brackets to four: 12%, 25%, 35% and 39.6%. This plan increases the lowest tax bracket by 2% and while the highest bracket stays the same, the threshold is increased from $470,700 to $1,000,000. Due to the condensing of the brackets, some taxpayers could actually be pushed into a higher bracket as well as losing the benefit of lower marginal tax rates, effectively increasing taxes for some.
Additionally, the plan contains the elimination of certain taxes. The most sweeping of those changes would be the repeal of the Alternative Minimum Tax (“AMT”), and elimination of the Federal Estate Tax. The AMT, a “shadow” income tax, has only been indexed to inflation since 2013; a tax that initially only affected 155 households now is paid by millions. The Federal Estate Tax, while it affects only 0.2% of U.S. households, contributes a substantial amount to the treasury. The current exemption amount for a married couple is $10.9 million, meaning that only estates worth in excess of that amount trigger the Federal Estate Tax. This plan would increase the exemption to $10,000,000 for single persons, and presumably $20,000,000 for married couples. The plan then proposes to eliminate the Federal Estate Tax completely after six years. You can expect much political infighting over both proposals.
The corporate tax rate, currently at 35%, is cut to 20% under this plan. While it is true that the US has one of the highest marginal rates in the world, virtually no corporation actually pays that rate. The average effective tax rate of corporations is 27.1% compared to the average tax rate of 27.7% from 30 other countries within the Organization for Economic Cooperation and Development (“OECD”). When looking at top US companies, the average effective tax rate is just 19.4%. It’s noteworthy that many top companies pay higher effective taxes in foreign countries than they do in the United States. It’s also worth mentioning that approximately 35% of all stocks are owned by foreign investors and according to Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, the 15% cut would cause approximately $70 billion per year to flow out of the United States and into the hands of these foreign investors.
In addition to all of this, one other provision with substantial consequences to the investment community is a proposal of a one-time “repatriation” tax of 12%, payable over eight years. Many large U.S. companies (think Microsoft, Apple, Google, many pharmaceutical companies, etc.) earn substantial revenue overseas, where it is held untaxed by the U.S. until the money is brought back, “repatriated,” to the U.S. Currently, there is over $2 trillion held overseas by US companies. Instead of repatriating the money now and paying a 35% tax, companies would now pay just 12% to repatriate the money. However, the plan does propose a substantial, and rather unexpected, change in that companies would be subjected to a 10% tax on their future worldwide income, whether or not the money is kept overseas.
The plan also calls for the elimination of most business deductions and credits, except the research and development credit; this includes an elimination of the interest deduction for businesses. However, it appears that companies with revenue less than $5 million will still be able to deduct interest on loans. Companies will also be allowed to immediately expense “qualified property” meaning that a company will no longer be required to depreciate an asset over a prescribed number of years; qualified property does not include buildings. Therefore, a business will not be able to buy a building and take a deduction for the full value of the building. However, this immediate expensing proposal has a five-year sunset provision, meaning it would end in 2023.
In Trump’s proposal, many questions arise as to how “pass-through” entities would be treated. Examples of pass-through entities are Limited Liability Companies (“LLCs”), “S” Corps, sole proprietorships and partnerships. What they have in common is that the entity bears no separate (corporate) tax, but rather the income is “passed through” and taxed on the owners individual income tax returns. Trump had proposed cutting the rates on pass through “business income” to as low as 15%. However, numerous complications arise with this plan and we don’t believe that any substantial planning should be done with this proposal in mind until the outlines become a great deal clearer.
A rather troubling provision is a proposal that implicitly repeals the Johnson Amendment to the Code which prohibited all tax-exempt entities from endorsing and opposing political candidates and engaging in political speech. The new plan removes the restrictions of the Johnson Amendment for only religious institutions. Thus, religious institutions, under this bill would be allowed to engage in political speech without risking their tax-exempt status. However, non-religious tax-exempt entities would risk losing their tax-exempt status if they were to engage in political speech.
Cutting across all of this is – no surprise – politics. Many economists, from both major political parties, have taken quick note that the proposal is clearly not “revenue neutral,” and that there is not even any general proposal as to how the reduction in Federal revenue collections would be offset. Initial calculations show that this plan will add approximately $1.5 trillion to the federal debt over ten years. To put that into perspective, this plan increases the federal debt by approximately $1 million every three and a half minutes.
Given the recent failure to repeal and replace the Affordable Care Act (“Obamacare” or “ACA”), even the most optimistic observers (except the President) do not believe that it will be possible to pass a new tax bill by the end of 2017. More likely, if tax reform does happen, it will likely not pass until 2018, just in time for midterm elections. We’ll attempt to follow the tortured path and keep you posted on some changes that may have impact on your business and personal tax planning.
Written by: Sherman F. Levey, Esq. and Jason W. Klimek, Esq., Boylan Code LLP