Donald Trump’s election as the 45th president of the United States was unexpected by most observers and potentially upends the tax landscape in a way that very few saw coming, even at 5 p.m. on Election Day.
With a bit of time having elapsed and speculation in full swing about administration appointments and legislative priorities, we examine the expressed tax proposals of the incoming administration and of Republicans controlling Congress, and we make some suggestions about future direction.
The Trump tax proposals and those of the Republican House of Representatives (“Blueprint”) are very similar in many key respects, “kissing cousins” in the words of House Ways and Means Chairman Kevin Brady, who says they are working on provisions of a bill and that “tax reform is going to occur in 2017.”
The coming year will be an interesting time on the legislative and administrative front, and it will be necessary for all of us to remain carefully tuned in to news coming out of Washington as the new administration confronts upcoming challenges and opportunities.
Our View: It is likely that 2017 will bring the most fundamental and comprehensive tax reform since 1986. It is likely that future income tax rates will be lower. In terms of current tax planning, that generally means a stronger-than-ever argument for accelerating deductions into 2016 to the extent possible, while deferring income to 2017.
Because the Trump plan and the Blueprint are so similar, we expect that some mix of the two will likely become law. The apparently pragmatic outlook of the incoming President, the reelection of Paul Ryan as Speaker of the House, and the appointment of Wisconsin’s Reince Priebus, a close friend and confidant of Ryan, as White House Chief of Staff, make that even more likely and lead us to believe that House Republicans will have a fair amount of leeway in crafting legislation, subject to the need to obtain approval in the Senate, where the margin is much closer.
Generally the Senate requires 60 votes to move on most legislation, so with 52 seats, Republicans would need some help from Democrats. A pragmatic President and a large number of Democratic seats up for reelection in 2018 in districts Trump carried may make it possible to get that help. In any event, a great deal of reform could also be moved through a complex process known as budget reconciliation, which requires only 51 votes in the Senate and is not subject to filibuster. However, the rules allow only items with a fiscal impact to be resolved through budget reconciliation, which leaves out “policy” items. In addition, fiscal scoring rules mean that any tax changes made through budget reconciliation will likely have a 10-year sunset provision, much as many of the Bush tax cuts did during the early part of the last decade. (Remember that President Obama allowed those cuts to expire at the end of the 10 years.) So while change is coming, it may not be permanent.
General Outlines of Potential Tax Reform
Potential Personal Income Tax Changes
Both Trump’s proposal and the Blueprint recommend lower personal income tax rates and expanded standard exemptions, while streamlining, aggregating, or eliminating a variety of other exemptions and preferences. Trump proposes three tax brackets, down from seven, of 12%, 25%, and 33% and repeal of the AMT. He would expand standard deductions and cap itemized deductions at a high level. Trump’s proposal, for example, would impose a $200,000 cap on all itemized deductions for married taxpayers filing a joint return ($100,000 for single filers). Current law does not impose such a cap. As a result, taxpayers considering large charitable deductions (or other deductible expenses) may wish to accelerate those deductions into 2016.
The Blueprint includes very similar provisions. Generally the Blueprint also suggests reducing the tax rate on dividends, interest, and capital gains to 50% of the ordinary rate, or 6%, 12.5%, and 16.5%. Both also call for the repeal of the 3.8% “Obamacare” tax, part of the promised repeal of the Affordable Care Act. Simplification and consolidation of a host of family-based, education, and similar tax credits are also proposed.
Over the past 15 years, there have been significant cuts in income tax, broadly aimed at the “middle class.” Because that group currently pays relatively little as a percentage of total federal taxes, they are likely to see far less benefit from the proposals than high-income earners. For many, the largest source of tax liability is the payroll tax, and that is not affected. On the other hand, because they pay by far the largest share of federal income taxes, high-income earners stand to see substantial potential benefit from any reform, in particular if flow-through income would be taxed differently, as described below.
The ultimate contours of individual income tax reform will undoubtedly not track exactly to the ideas outlined above, but we can paint a broad picture, and it will be necessary for taxpayers and advisors to evaluate changes to their specific circumstances. Note, too, that there is no entirely free lunch. In order to pay for simplification and lower rates, many tax preference items could be on the menu for elimination. The Blueprint is more focused on “pay fors” than the Trump plan, with the latter creating a much larger fiscal hole. Stay tuned.
Potential Corporate and Business Tax Reform
Corporate and business tax reform is perhaps the area that could see the most significant change. Both the Trump plan and the Blueprint reduce C-corporation tax rates, Trump’s to 15% and the Blueprint to 20%, from 35%. The goal of these reductions is to make the United States more competitive in a global environment. Along with lower rates, there would be provisions designed to encourage repatriation of previous foreign earnings, perhaps a 10% rate on those earnings. Importantly, it appears that the proposals would shift the corporate tax system from one of a tax on worldwide income to one that taxes income on a territorial basis. That would align the U.S. system more closely with most of the world and would eliminate one of the major reasons for U.S. companies moving overseas or utilizing so-called “inversion” transactions.
The proposals also generally call for the elimination of depreciation deductions in favor of immediate expensing, though at the loss of a deduction for net interest expense. The plans generally call for the elimination of a variety of what are called “special interest loopholes,” corporate tax deductions and credits, in exchange for a simpler system and lower overall rates. The corporate alternative minimum tax would be eliminated, and the R&D credit would be retained. LIFO inventory would be retained, and the DPAD deduction would be eliminated.
These proposals generally mean that C-corporation income should be postponed. Subject to the discussion below on flow-through income, S corporations and other flow-through entities may want to consider whether converting to C-corporation status would be beneficial. The combination of lower corporate rates and lower dividend rates, as discussed above, could tilt the playing field in favor of C corporations. It is at least possible that deferring capital asset acquisitions could make sense because of the potential ability to immediately expense them under a change to the law.
One of the most interesting parts of both the Trump plan and the Blueprint is a proposal to “level the playing field” for small business. For this purpose, “small business” generally means sole proprietorships and flow-through entities for which business income is generally taxed at personal income tax rates, which today can be as high as 44.3% when “Obamacare” taxes are factored in.
Both the Trump plan and the Blueprint suggest that the active business income of these small businesses and flow-through entities would be taxed at lower rates than today. The Trump plan has suggested 15%, and the Blueprint suggests 25%. Whatever the ultimate rate that applies, these represent a substantial potential reduction from current marginal rates on small business income that is taxed to the business owner. The Blueprint provides a bit more detail than the Trump plan on the workings of this provision and states:
“Under this new approach for taxing small businesses, sole proprietorships and pass-through 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. The compensation that is taxed at the lowest individual tax bracket rate of 12 percent effectively will further reduce the total income tax burden on these small businesses and pass-through entities.”
While much would remain the same, these provisions would introduce a very different tax regime for business, and entity structure would become a focus for evaluation. Of course, until the ink is dry on the President’s signature, a tax bill is open to negotiation and change, and hasty action based on the proposals outlined above, or any other, runs the risk of being wrong. However, the likelihood of corporate reform is very real, and it will present a planning challenge and opportunity for businesses of all sizes.
Potential Estate Tax Repeal
Both President-elect Trump and the Blueprint propose estate tax repeal, and we believe it is likely to occur. With increased exemptions over the last several years, the estate tax does not impact many taxpayers or generate a great deal of revenue by the standards of modern government; in 2015 fewer than 5,000 estates paid a total of about $17 billion in estate taxes (less than 1% of federal revenue). Those numbers make the estate tax an easy target, and many view its existence as more of a social engineering tool than a tool for raising federal revenue and, as a result, see it as an economic distortion.
It remains to be seen whether a repeal would be effective immediately or effective over some phased-in period of time as it was under the Bush tax cuts. Given the smaller dollars at stake relative to other provisions, a desire to generate simplicity, and the significant symbolic value of its abolition, we believe there is a strong possibility a repeal would be effective upon enactment of tax reform.
Generally it seems likely that if the estate tax is repealed, the gift tax and generation-skipping transfer tax would also be repealed. Because the gift tax arguably provides some backstop to the income tax by making it more difficult for wealthy individuals to shift income among family members, there is some chance it could be retained in some form.
Estate tax repeal is not likely to be entirely free, however. Current law permits a step-up in income basis at death for most assets included in the taxable estate of a decedent, meaning that the assets can later be sold at no gain on that amount for income tax purposes. The Trump plan suggests limiting that step-up to the first $10 million of assets, meaning assets in excess of that amount would not receive a basis step-up and could face income tax exposure if they are later sold.
Many taxpayers are aware of proposed changes to certain estate tax regulations that would impact the valuation of family business interests and certain of the tools related to transfers of those interests. Indeed, many taxpayers have been working to complete such transfers ahead of the end of this year, concerned that the regulations might go into effect at January 1 or any time thereafter. Given our view that the estate tax might have a short shelf life, we believe it less likely that these regulations will be implemented, and if the estate tax is repealed, they will be of no consequence. Taxpayers should consult with their advisors and consider whether a pause to evaluate is appropriate.
Our general view is that taxpayers and clients should not use potential estate tax repeal as an excuse not to do estate or business succession planning because that exercise is important for many reasons. However, we believe it is important to consult with your advisors as to whether to stop planning or move forward, and for some it may be appropriate to tap the breaks on estate tax-driven transactions and be watchful as events unfold. If repeal does occur, it will be necessary to consider changes to existing plans based on the landscape that unfolds. Taxpayers and their advisers are likely to be very busy, in any event, but should not make any drastic changes until the actual contours of any changes are known.
On many fronts, we believe there is a lot to watch in 2017. With respect to taxes, we believe 2017 is likely to be the most consequential year since 1986 when a huge tax overhaul occurred. Taxpayers should not rush to make changes based on any proposals that have been made public, because the ultimate contours of any legislation are likely to be different, but tax rates are likely headed lower. Taxpayers should keep an eye on legislation and consult regularly with their advisors. If and when we have legislation, it will require all taxpayers to understand the impact that legislation will have on them and how best to adapt. Wipfli will be watching closely, and your Wipfli relationship executive will be ready to help you.
Authored by Jeff Kowieski with contributions from Rick Taylor and Ryan Laughlin.