May 3, 2017 – President Donald Trump on April 26 announced the framework of his long-awaited tax plan. Its stated goal is to simplify and make the tax code more competitive, promote job and economic growth, and help low- and middle-income taxpayers.
A number of details will be worked out before a final tax reform package is presented. Moreover, because several details are missing, it is too soon to calculate the actual impact of the changes on any one taxpayer. Doing so at this point is largely speculative. However, the announcement signals the first step to bring long-discussed tax reform in the U.S. The White House is stating that the plan represents “one of the biggest tax cuts in history.” Depending on what comes out of the Congress, it could be.
Simplification for Individuals
A stated aim of the reforms is simplification of the code. A reduction in tax brackets, doubling the standard deduction, and limiting deductions does simplify return preparation. These changes would decrease the number of taxpayers completing a Schedule A (itemized deductions) and reduce the time needed to complete a tax return.
Robert B. Teuber (Marquette 2000) is a shareholder in the Milwaukee office of von Briesen & Roper S.C. He focuses on tax disputes and controversies. Reach him by email or by phone at (414) 270-2538.
Many low- and middle-income taxpayers who do not itemize deductions would benefit. In 2016, those “married filing jointly” taxpayers that did not itemize their deductions received a standard deduction of $12,600. This meant that the first $12,600 in income was tax-free. Under the proposal, the increase in the standard deduction will mean these same taxpayers will not pay tax on the first $24,000 earned.
While simplification and reductions in tax rates are positives for individual taxpayers, there are some losses with an unknown impact. In doubling the standard deduction, the Trump tax plan is eliminating several deductions. At this point, taxpayers can only infer what these lost deductions will actually be. The administration has stated that the home mortgage interest and charitable contribution deductions would be preserved.
If all other itemized deductions from Schedule A are eliminated, some of the deductions that taxpayers may lose include:
- state and local income/sales taxes;
- real estate taxes;
- casualty and theft losses;
- unreimbursed employee expenses;
- medical and dental expenses; and
- gambling losses (only deductible to the extent of winnings).
It is unclear at this point if itemized deductions on Schedule A will be the only lost deductions or whether the “above the line” deductions, such as alimony, student loan interest, half of the self-employment tax, and other deductions found at the bottom of the first page of Form 1040 are also at risk. According to the plan, however, the deductions for retirement savings will be preserved.
More Details on Deductions/Rates
The loss of the itemized deduction for state and local taxes will likely have a larger negative tax effect on those taxpayers who itemize deductions and live in high tax states such as many in the Northeast and California.
Capping the capital gains tax at 20 percent and repealing the 3.8 percent net investment tax and the alternative minimum tax (AMT) will likely work to reduce the tax burden on upper-middle and upper-income taxpayers.
Current unknowns include the extent of the child/dependent care benefits that will be included in the plan and to what income levels the reduced tax rates will apply.
In 2016, a 25 percent tax rate was imposed on income between $75,301 and $151,900 for those taxpayers married filing jointly. Under the Trump tax plan, it has not yet been determined on what income levels the new 10 percent, 25 percent, and 35 percent rates will be imposed. Where these rates land can have a significant impact on the amount of tax relief actually granted to taxpayers and whether the greatest tax relief is granted to lower-, middle-, or upper-income levels.
Summary: Tax Reform in the Works
For Individuals, the Trump tax plan would:
- reduce the current rates and tax brackets from the current seven (10%, 15%, 25%, 28%, 33%, 35% and 39.6%) down to three brackets (10%, 25%, and 35%);
- repeal the alternative minimum tax, the “death” tax, and the 3.8% net investment income tax;
- double the standard deduction to $24,000 for those married filing jointly and to $12,600 for singles or those married filing separately;
- eliminate deductions but preserve those for home mortgage interest, charitable contributions, and retirement savings;
- include child/dependent care benefits;
- fix the maximum capital gain and dividend rates at 20%.
For Businesses, the Trump tax plan would:
- impose a 15% tax rate (down from the current 35%) on corporations and on pass-through business income;
- convert to a territorial tax system;
- include a one-time tax on the repatriation of funds to the U.S.
The repeal of the estate or “death” tax has long been a goal of Republican tax reform efforts. Under the existing tax structure, when a taxpayer dies, the heirs receive property from the decedent’s estate with a “stepped-up basis.”
This allows the heir to only pay tax on gains accruing after the death of the decedent. The result is that capital gains tax is not paid on any increased value of the property while in the hands of the decedent. The repeal of the estate tax raises the question of whether the stepped-up basis rules will be retained in some manner or eliminated.
Prior discussion on Trump’s plan for eliminating the estate tax suggested that the step-up will be preserved to some extent, but not for larger estates. This would mean an increased need for taxpayers to track the basis of their assets prior to their death to ensure that their heirs do not pay tax on gains that do not actually exist.
Impact of Proposed Tax Reform on Businesses
There is less to be said about the broad strokes of the corporate tax reform proposal. While the changes are significant, many details will need to be worked out as the process moves forward. The stated goal of corporate tax reform is to make the tax system competitive and less complex. By being more competitive, the administration hopes to incentivize companies to stay in and come to the United States.
The plan would accomplish this through a 15 percent tax rate on corporations, by creating a territorial tax system, and by imposing a one-time tax on repatriated funds. The reduction to a 15 percent corporate tax rate will also apply to pass-through entities such as S corporations, partnerships, and LLCs. Doing so will avoid a disadvantage to business owners who operate through pass-through entities rather than as C corporations.
Currently, those who own pass-through entities pay tax on the net income of the business at their individual income tax rates on their own Form 1040. Under the Trump tax plan, individual rates will be higher than the new 15 percent corporate tax rate.
Without access to the 15 percent tax rate available to corporations, pass-through owners would end up paying more tax on their business income than would large corporations. Therefore, it is necessary to bring these rates into parity.
Applying the 15 percent rate to pass-through income may not be easy, and new rules will be necessary to prevent a new era of tax shelters. To ensure that wealthier taxpayers do not shift income subject to the proposed individual 25 percent or 35 percent tax rates into a 15 percent pass-through rate, additional safeguards would be needed. The administration has explained that these rules are being developed through discussion with legislators and will require time to complete.
Territorial Tax System
Converting to a territorial corporate tax system is another significant change. Currently, corporate taxpayers are taxed on their worldwide income. By joining the rest of the world in a territorial tax system, only the income earned within the U.S. would be subject to tax in this country. Together with the one-time tax on the repatriation of foreign earnings, the intention of the Trump tax plan is that companies will be incentivized to remain in the U.S. and will not move overseas by use of the much maligned corporate inversions criticized by Republicans and Democrats alike.
When Will We See Actual Reform?
The Trump tax plan outlines the framework that will likely drive the tax reform discussion. We can only make predictions on what tax reform will actually look like after grinding through the legislative process.
Many questions need answers, including how the tax cuts will be paid for and whether the cuts will be retroactive. For the answers to these questions, we’ll have to wait. If we are so bold as to listen to Washington, we should have reform yet this year.