A View from Washington: Tax Reform and its Trade-Offs
- Tax Planning
With the failure of Congressional Republicans to repeal and replace the Affordable Care Act, tax reform now moves to the front of the line as the White House and Republicans look for their first major legislative policy win. The Republicans control Congress and the Presidency for the next two years which creates a sense of urgency to pass tax reform before the 2018 mid-term elections.
Tax reform with lower tax rates sounds great. However, tax reform is like an iceberg. What’s under the water and not seen is often more important. Tax reform plans create winners and losers and the House Republican leaders’ current plan (“Blueprint”) is no exception. As of this writing, it looks like the House Ways and Means Committee is planning a series of tax reform hearings around the Blueprint in May to June with Committee and full House approval planned before the August Congressional recess.
For this article, I focus on the Blueprint, which is the baseline tax reform proposal, and highlight considerations for individuals and small business. Future articles will review progress on tax reform as other stakeholders, like the White House and Senate, react to the Blueprint with their own ideas and discuss how the Senate’s arcane budget rules will shape the final deal. Keep in mind we are in the very early stages of the debate. I remain confident tax reform comes together in 2017.
Individual and Small Business Tax Reforms
|What’s in The Blueprint?|
Generally, the Blueprint is good news for individuals and small businesses that pass most of their income to owners (e.g. partnerships, LLCs, and S corporations). The Blueprint focuses on simplifying, flattening, and lowering tax rates on ordinary income, capital gains, dividends and interest income. It does this by replacing the existing seven tax brackets, with the highest tax rate at 39.6%, into three brackets with the highest rate at 33%. In addition, 50% of the net income from capital gains, dividends, and interest income would be excluded from tax. The result is a maximum 16.5% rate for higher income earners on investment income and capital gains.
Additionally, the Blueprint promises a special lower tax rate of 25% for active business income. House Republicans campaigned on this special tax rate for small business during the 2016 election. However, many Republicans, including the White House, are having second thoughts about the proposal because of tax compliance concerns. Tax compliance experts fear there will be a massive reclassification of wage income (taxed at higher rates) to active business income (taxed at the special 25% rate). I expect this provision will be either eliminated or limited as tax reform advances.
The Blueprint also calls for the repeal of the estate tax and the individual alternative minimum tax. Repeal of the estate tax remains one of the most popular with small business owners. However, the Blueprint does not repeal the 3.8% tax on net investment income included in the Affordable Care Act (“ACA”). The assumption is this tax would be repealed as part of the Republican’s plan to repair or replace the ACA, which has stalled.
In the category of simplification, the Blueprint calls for the elimination of most deductions, exemptions and credits for individuals that riddle the tax code. Buried in the details of the Blueprint, the interest deduction on existing home loans and refinancing is preserved but is eliminated for new home mortgage loans and business loans. Additionally, itemized deductions under current law are replaced with a larger standard deduction. The charitable deduction is maintained but may provide less direct tax benefits if individuals forgo itemizing their deductions in favor of a larger standard deduction.
Disallowing interest deductions on new loans and eliminating most itemized deductions raises about $2 trillion in new tax revenue and basically pays for the cost of lowering the tax rates on individuals and small businesses. These are the types of tradeoffs that are included throughout the Blueprint which have the potential to impact your individual financial situation.
"Buried in the details of the Blueprint, the interest deduction on existing home loans and refinancing is preserved but is eliminated for new home mortgage loans and business loans."
Corporate Tax Reforms
"Elimination of the tax code’s complex depreciation rules is an important step toward simplification."
Corporate tax reform is the main driver behind tax reform. Today, larger businesses that operate as “C” corporations are subject to a corporate tax rate of 35% compared to some overseas competitors which are taxed at an average rate of 24.8%. To solve this inequity, the Blueprint lowers the corporate tax rate to a flat rate of 20%. As noted above, net interest expense (interest expense exceeding interest income) would no longer be deductible. For financial services companies like banks, insurance and leasing where interest income is core to their revenue models, the Blueprint includes special rules preserving the interest expense (that is eliminated for most non-financial companies).
To buffer the tax impact of losing the interest deduction, businesses would be allowed an immediate write off of the cost of business investments. Elimination of the tax code’s complex depreciation rules is an important step toward simplification. In a nod to American innovation, the research and development credit is preserved under the Blueprint.
In summary, corporate tax cuts total about $4 trillion and are partly offset by the following tax increases:
- Disallowance of net interest expense
- Elimination of most business credits
- Disallowance of net operating loss carrybacks
- 8.75% tax on foreign earnings held in cash and repatriated to the United States
- Creation of a new border adjustment tax (“BAT”).
The proposed BAT tax is worth considering in more detail because it would be a fundamental shift in our corporate tax structure. It is the most controversial component of the Blueprint and is drawing a great deal of opposition from industries that import most of their goods for sale in the United States.
Under a BAT, the income tax would apply to businesses’ income from sales in the United States.
Today, the income tax applies to businesses’ income from production in the Unites States regardless of where the goods are sold. This means that products and services that are exported will not be subject to United States tax. On the flip side, goods and services imported for sale in the United States would be taxed.
Politicians from states with companies that import most of the goods they sell domestically (like retailers) are very concerned that a BAT would increase prices for consumers because of the tax. I expect this provision will be significantly modified or dropped from the Blueprint as tax reform advances because of these concerns.
Closing Thoughts and Takeaways
- Become familiar with the Blueprint, but know the contents will change over time.
- Keep your eye on the tax increases. It’s not all tax cuts.
- Don’t plan on a top tax rate of 25% on your active business income as promised in the Blueprint. It is too good to be true.
- Don’t fear the BAT. It will be significantly modified or dropped.
- Call your Boston Private Advisor or your tax advisor if you have questions about how tax law changes could impact your assets and liabilities.
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Doug is Director of Retirement Policy at the American Retirement Association. In this role, Doug works with the ARA membership to protect, advise and grow their businesses through ideation and advocacy in the benefits area. Before joining ARA, Doug led Fidelity's legislative policy and thought leadership development teams involving retirement, health and welfare benefit plans. Doug also served as tax counsel to the U.S. Senate Finance Committee and was involved in writing the pension, health and insurance provisions of the Small Business Job Protection Act of 1996; the Balanced Budget Act of 1997, including the Roth IRA, Simple retirement plan, medical savings account (predecessor to the health savings account); and the Health Insurance Portability and Accountability Act of 1996 (HIPAA).
- Tax Planning