Down, but Not Out: Important Tax Changes Included in Deficit Commission Study Will Resurface in Coming Months


December 7, 2010
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On Friday, December 3, a bipartisan majority of commissioners of President Obama's National Commission on Fiscal Responsibility and Reform voted their support for the ambitious package of tax reforms and spending cuts. However, with 11 of 18 members backing the plan, it was still three votes short of the supermajority required to send the plan to Congress for action under the terms of the President’s executive order establishing the commission. Congressional leaders had said they would put the plan to an up-or-down vote in Congress if 14 of 18 commissioners supported it.

Although the proposal did not survive the vote, both Democratic and Republican lawmakers praised the tax portion of the plan, suggesting it could survive as the basis of future bipartisan tax reform discussions. As a result, we thought it would be beneficial to alert you to some of the important tax provisions included in the deficit study. Our view is that a number of these proposals may be enacted in the future and could significantly impact your family and your business.

Is a Flat Tax in Your Future? 

In 1996, Steve Forbes ran for the Republican Presidential nomination on a platform that called for a flat 17% tax on wages and salary. His proposals were considered too radical at that time and generally were not taken seriously by the mainstream media and politicians. That is why it is so interesting that the deficit study proposes a variation of the flat tax that is significantly closer to Forbes’ proposal than our current system.
The primary advantages of a flat tax are that it is easy to understand and is perceived by many to be fairer since the vast array of special deductions, exemptions, and credits are eliminated. Opponents point to the regressive nature of a flat tax, notwithstanding the minimum exemption levels below which tax is not imposed.
The deficit plan would eliminate most tax expenditures (deductions) and set individual rates at 8%, 14%, and 23%. Unlike the Forbes plan, which eliminated all deductions and credits, the deficit plan calls for retention, with new limitations, of key preferences in the current code —mortgage interest, employer-provided health care, charitable giving, and retirement savings/pensions — and includes an add-back mechanism that requires any other expenditures to be offset with rate increases. In no case would the top individual tax rate exceed 29%.

The current mortgage interest and charitable giving deductions would be converted to 12% nonrefundable tax credits, with the mortgage interest credit limited to the first $500,000 in mortgage debt on principal residences. The charitable giving credit would be available above a 2% of adjusted gross income (AGI) floor. The current exclusion for employer-provided health care would be capped based on premium levels.

All tax expenditures for corporations — the domestic production deduction(DPAD) and last-in/first-out (LIFO) method of accounting are specifically mentioned in the report — would be eliminated, and a single corporate tax rate between 23% and 29% would be set (the commission gives 26% as an example). The plan also promotes a switch to a territorial tax system for taxing the active foreign business earnings of U.S. companies, while retaining the current Subpart F rules (taxing currently passive foreign-source income). This change is needed because the current tax system leaves U.S. corporations hamstrung in competing with foreign corporations.

The charts below illustrate some of the key provisions included in the deficit plan. We believe these provisions will resurface in the coming months as Congress looks for ways to reform the existing Tax Code. Congress clearly has its eye on taxing capital gains and dividends as ordinary income and limiting the cherished mortgage interest and charitable deductions. Also worth noting is that this is the first time we have seen proposals to severely limit the amount you can put away for retirement on a tax-deferred basis, although this is not completely surprising given the need to raise revenue.

Tax Rates Under Various Scenarios

Bottom Rate

Middle Rate

Top Rate

Corporate
Rate

Current rates for 2010

10%

15%

25%

28%

33%

35%

35%

Scheduled rates for 2011

15%

28%

31%

36%

39.6%

35%

If eliminate all tax exemptions, deductions, and credits and tax capital gains and dividends as ordinary income, tax rates could be reduced

8%

14%

23%

26%

Same as above, but also keep the child tax and the earned income tax credits

9%

15%

24%

26%

Enact the illustrative tax
plan below

12%

22%

28%

28%

 The following chart compares the current tax treatment of several key components for individuals with how they would be taxed under the new proposal.

  

Current Law

Proposal  

Tax Rates for Individuals

In 2010, six brackets:
10%, 15%, 25%, 28%, 33%, 35%
 

In 2011, five brackets:
15%, 28%, 31%, 36%, 39.6%

Three brackets: 12%, 22%, 28%

Alternative
Minimum Tax

Scheduled to hit middle-income individuals but “patched” annually

Permanently repealed

PEP and Pease1

Repealed for 2010, resumes in 2011

Permanently repealed

EITC and Child
Tax Credit

Partially refundable child tax credit
of $1,000 per child. Refundable EITC
of between $457 and $5,666

Maintain current law or an equivalent
alternative

Standard Deduction and Exemptions

Standard deduction of $5,700 ($11,400 for couple) for nonitemizers; personal and dependent exemptions of $3,650

Maintain current law; itemized deductions eliminated, so all individuals take standard deductions

Capital Gains and
Dividends

In 2010, top rate of 15% for capital
gains and dividends. In 2011, top rate
of 20% for capital gains, and dividends taxed as ordinary income.2

All capital gains and dividends taxed at ordinary income rates3

Mortgage Interest

Deductible for itemizers; mortgage
capped at $1 million for principal and
second residences, plus an additional $100,000 for home equity

12% nonrefundable tax credit available
to all taxpayers; mortgage capped at
$500,000; no credit for interest from
second residence and equity

Employer-Provided Health Care Insurance

Excluded from income; 40% excise
tax on high-cost plans (generally
$27,500 for families) begins in 2018;
threshold indexed to inflation

Exclusion capped at 75th percentile of
premium levels in 2014, with cap frozen
in nominal terms through 2018 and
phased out by 2038; excise tax reduced
to 12%

Charitable Giving

Deductible for itemizers

12% nonrefundable tax credit available
to all taxpayers; available above 2% of
adjusted gross income (AGI) floor

State and Municipal Bonds

Interest exempt from income

Interest taxable as income for newly
issued bonds

Retirement

Multiple retirement account options
with different contribution limits;
saver’s credit of up to $1,000

Consolidate retirement accounts; limited
tax-preferred contributions to the lower of $20,000 or 20% of income; expand
saver’s credit

Other Tax
Expenditures

Over 150 additional tax expenditures

Nearly all other income tax expenditures
eliminated4

1  PEP is the Personal Exemption Phaseout; Pease is the phaseout of itemized deductions. PEP and Pease have phaseouts at different levels and are viewed as stealth taxes.
 
2  Collectibles (e.g., coin, art, antiques) are taxed at 28%, and unrecaptured gain on real estate is taxed at 25%.
 
An alternative could be to exclude a portion of capital gains and dividends from income (e.g., 20%), reducing the effective top rate on investment income. To offset this while maintaining progressivity in the Code, the top rate on ordinary income would need to be increased.
 
Under this plan, a few tax expenditures remain; for instance, no changes are made to the tax treatment of employer pensions, and tax provisions under PPACA largely remain in place. Note that the payroll tax base would remain the same as under current law, though there will be secondary revenue effects on the payroll tax side. 

As mentioned above, the proposals in the deficit plan would make significant changes to the way corporations and other businesses are taxed by eliminating the domestic production deduction (DPAD), requiring the use of FIFO inventory (thereby eliminating more beneficial methods of determining inventory, including LIFO) and eliminating all tax credits and special exemptions. It is interesting that despite all the negative publicity regarding U.S. corporations moving jobs abroad, the proposal would actually provide a significant benefit to companies that produce goods and services offshore. The chart below shows how the proposal compares to current law in the corporate tax arena.

Corporations

Current Law

Proposal

Corporate Tax Rates

Multiple brackets, generally taxed at 35% for large corporations

One bracket: 28%

Domestic Production
Deduction

Up to 9% deduction of Qualified
Production Activities Income

Eliminated

Inventory Methods

Businesses may account for inventories under the last-in, first-out (LIFO) method of accounting

Eliminated with appropriate transition

General Business Credits

Over 30 tax credits

Eliminated

Other Tax Expenditures

Over 75 tax expenditures

Eliminated

Taxation of Active
Foreign-Source Income

Taxed when repatriated (deferral)

Territorial system

Taxation of Passive
Foreign-Source Income

Taxed currently under Subpart F

Maintain current law

Clearly, the tax provisions included in the deficit plan proposal would significantly alter the current Tax Code. Note again that while the deficit plan as a whole failed to move forward for a full Congressional vote, the tax piece of the plan received widespread bipartisan support and may very well serve as the groundwork for a tax law overhaul in the near future.

Contact your Wipfli relationship executive or Rick Taylor at 414-431-9385 with any questions or to discuss how expected tax changes will impact you and your business.

This information is provided solely for general guidance and informational purposes only and does not create a business or professional services relationship. Accordingly, this information is provided with the understanding that the authors and publishers are not herein engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal, or other competent advisers and cannot be relied upon by any taxpayer for the purpose of avoiding penalties imposed under the Internal Revenue Code. Before making any decision or taking any action, you should obtain appropriate professional guidance.

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