By Glenn James
It’s been three months since the publication of our first article on tax reform titled: “Federal Tax Reform: What We Are Likely to See in 2017.” At least two major events discussed in that article have already transpired.
First, with barely a moment’s hesitation, the U.S. Senate majority acted by a vote of 52 to 48 to further limit the application of Senate Rule 22 (known as the “Filibuster” or the “Cloture” rule) and reduce the number of senators required to confirm a U.S. Supreme Court justice nomination to a simple majority of 51. The president’s nominee to the Court, Neil Gorsuch, was then promptly confirmed with 54 votes. And now all presidential nominees can be confirmed in the Senate with a simple majority vote.
Considering these developments, it is difficult to construct a compelling argument that assumes the majority party would not also repeal Rule 22 to advance tax legislation and a budget resolution. If that occurs, the congressional minority might well become irrelevant in the short term, in which case, the future of tax reform will be dependent solely upon the ability of the congressional majority to line up its own members behind whatever legislation the majority leadership proposes.
The initial failure of the majority party to bring a bill repealing the Affordable Care Act of 2010 to a floor vote fueled doubts that the majority would be able to build consensus on such sweeping policy changes. That doubt was beaten back when, rather abruptly, a repeal and replace bill, the “American Health Care Act,” was passed six weeks later in the U.S. House of Representatives by a vote of 217 to 213. Tax reform should be much less controversial than healthcare, especially given that, in broad principle, the majority proposal and the president’s campaigned-on proposal are substantially identical.
Accordingly, it now appears more likely than not that tax reform will be enacted this year which will represent a sea change in the way the U.S. taxes business entities. The president and his spokespeople have, since our last article, issued further commentary that can be regarded as an abbreviated, updated proposal. Here is what we can anticipate based on what they are telling us now.
Tax reform proposals: Candidate Trump vs. President Trump
The president’s campaigned-on proposal called for a reduction in the top individual tax rate from the current 43.4 percent (39.6 percent regular income tax plus 3.8 percent investment income tax) to a 33 percent rate (33 percent regular income tax and no net investment income tax). The president’s latest proposal calls for a reduction only to 35 percent (35 percent regular income tax and no net investment income tax).
The president’s latest proposal apparently remains in line with his campaigned-on proposal and keeps the maximum rate of taxation on long-term capital gains and corporate dividends at 20 percent. And just as in the president’s campaigned-on proposal, the revised proposal eliminates personal exemptions, eliminates itemized deductions (except for home mortgage interest expense and charitable contributions), may cap those deductions at $200,000 for a married couple ($100,000 single), and may eliminate most deductions against gross income to arrive at adjusted gross income except for retirement savings deductions.
The latest proposal calls for the elimination of a number of tax breaks, including the so-called “carried interest” that taxes investment fund managers on their performance-based compensation at capital gains tax rates rather than ordinary income tax rates. It also proposes eliminating tax breaks relating to items that are considered preferences under the current alternative minimum tax regime.
While the president’s latest proposal continues to call for repeal of the net investment income tax and the alternative minimum tax, it remains silent, as did the campaigned-on proposal, with respect to the fate of the Medicare surtax introduced under the Affordable Care Act of 2010. Individual members of Congress have suggested that the surtax may be kept in order to fund costs that will continue under the American Health Care Act.
The president’s latest proposal, like the campaigned-on proposal, also calls for elimination of the federal estate tax (the “Death Tax”), apparently accompanied by an elimination of the “step-up-in-basis” presently given to property passing through an estate.
In relation to business entities (corporations, S-corporations, partnerships and limited liability companies), the latest proposal, like the campaigned-on proposal, continues to call for a 15 percent income tax rate, parity between so-called C-corporations and pass-through entities, and base broadening by elimination of deductions and other tax breaks to business entities.
What to make of what we know now
The prospect of tax reform suggests the following action: Corporations should be prepared for a substantial write-down of their deferred tax assets on account of the corporate tax rate reduction.
Business entities should, to the extent possible, accelerate deductions into 2017 and defer income to later years (hedging against the possibility that reform will not take effect until 2018). This means that even those business entities not typically interested in deductions representing merely a deferral of tax because of their low cost of borrowing—i.e., banks—ought to have a keen interest in all such strategies because they may very well represent substantial permanent tax savings due to the reduction in tax rate.
After considering the individual tax-benefit eliminations in the latest proposal as well as the somewhat nominal decrease in the top tax rate, it would appear that individual taxpayers don’t stand to gain a great deal under tax reform except, perhaps, simplicity. Nevertheless, individuals should, to the extent they are able, apply the same strategy suggested above for business entities, which is to say they should defer income and accelerate deductions in order to position themselves to benefit in the transition.
Tax reform now seems to be definitely on the way, and barring the continued escalation of controversy swirling around the Oval Office, the GOP seems resolved to come together to push reform through.
This article originally appeared in BDO USA, LLP’s “Financial Institutions in Focus” newsletter (Summer 2017). Copyright ©2017 BDO USA, LLP. All rights reserved. www.bdo.com