As the third quarter of the year comes to a close, President Donald Trump presented his tax plan for reforming the U.S. tax code. Since this is only the first cut proposal that now must be written and approved by Congress, there are many unanswered questions. There is no indication of a proposed effective date for these changes nor are there indications of what income levels will be taxed at which tax bracket.
Given the divisions in Washington, it’s impossible to answer those questions with any certainty. Nevertheless, knowing the broad strokes of this proposal may be helpful in year-end tax planning. For now, here are the major tax changes the President would like to implement:
Lower tax rates for individuals
Personal income tax rates now fall into seven brackets, ranging from 10% to 39.6%. The framework calls for reducing the number of tax brackets to three: 12%, 25%, and 35%. (Other changes, described below, are intended to reduce the taxes paid by those now in the 10% bracket.)
The proposal notes that an additional top tax rate may apply to the “highest-income taxpayers,” without mentioning the income level at which such a rate might take effect or the rate that would be imposed.
Higher standard deduction, less itemizing
Currently, taxpayers can choose to claim either a standard deduction or itemize deductions, if the latter will lower their tax bill. In 2017, the standard deduction is $6,350 for single taxpayers and $12,700 for married couples filing joint tax returns.
The Trump proposal would nearly double the standard deductions to $12,000 and $24,000, respectively. In return, the deduction for personal exemptions for dependents would be repealed, as would most itemized deductions. Only home mortgage interest and charitable contributions would remain as itemized deductions. This means that large medical expenses, state and local income taxes, real estate taxes, investment expenses and investment interest expense would no longer be deductible.
Such a revision of the tax code, if enacted, would greatly increase the number of taxpayers choosing the standard deduction.
Other personal provisions
The alternative minimum tax (AMT) would be repealed. It is interesting to note that the addback of the deduction for state and local income taxes and real estate taxes is the one item that subjects most taxpayers to the AMT. Since that deduction is being eliminated, it is likely that most people would no longer be subject to the AMT if it was retained.
This plan specifically mentions that the Child Tax Credit would increase, with savings, including a refundable portion, offered to taxpayers who have higher levels of income than current law allows. A credit for non-child dependents also would be included.
Beyond those items, the framework indicates that tax provisions designed to encourage work, higher education and retirement security will be retained. Reading between the lines, it appears that the current system of tax-favored retirement plans (401(k)s, IRAs, etc.) generally will remain in place.
While impossible to say with any certainty, it appears that the lowering of tax rates and repeal of the AMT will more than be offset by the elimination of major categories of itemized deductions, resulting in higher tax bills for the wealthy.
Death of the Estate Tax and Generation Skipping Transfer Tax
The federal estate tax and generation-skipping transfer tax would be repealed under this framework. While not yet specifically mentioned, it is suspected that that the repeal will apply to gift taxes, as well.
There was no mention of how a decedent’s appreciated assets would be treated. Prior Trump proposals were unclear as to whether an income tax would be paid on the value in excess of tax basis at death or upon a later sale. In addition, there was no information on a limited “step-up in basis” to date of death value for smaller estates.
Lower tax rates for businesses
Currently, so called regular or “C” corporations pay income tax at rates up to 35%. Trump would reduce this rate to 20%, which he says is more in line with corporate tax rates around the world. The corporate AMT would also be eliminated and other methods to reduce the double taxation of corporate earnings, such as a partial corporate dividends paid deduction, may be considered.
Many small businesses (and not so small businesses) are instead structured as “S” corporations, partnerships, limited liability companies (LLCs), or sole proprietorships; all of which pass through business profits and losses to their owners’ personal tax returns. Thus, “C” corporation income taxes may be avoided but the owners face personal tax rates as high as 39.6%.
Under the proposed framework, business income from such “pass-through entities” would be taxed at a rate no higher than 25%. The term “small businesses” raises the possibility that certain large “pass-through entities” would be excluded from this lower tax rate. As noted in the White House announcement, such a measure would need to be drafted carefully in order to prevent personal income of wealthy individuals from being recharacterized into lower-taxed business income. Furthermore, the issue of whether distributions would then be subject to a second level of tax at the individual owner level needs to be addressed.
Specialized business deductions
Besides reduced income tax rates, the proposal mentions several business-related provisions:
Aiming for worldwide fairness
President Trump has made the taxation of offshore business profits a major issue. By adopting a territorial system of taxation, the plan would exempt foreign profits from U.S. income tax when they are repatriated to the United States, by enacting a full tax exemption for dividends from foreign subsidiaries, if the U.S. parent owns at least a 10% stake.
In order to transition to the new system, the framework would treat foreign earnings that accumulated under the old system as repatriated. There are no specified rates for this one-time deemed repatriation tax. The tax on the deemed repatriated foreign earnings will depend upon the type of assets that are owned. Illiquid assets will be subject to a lower tax rate than cash or cash equivalents, and the payment of the tax liability will be spread out over several years. This provision appears designed to provide the needed budgetary revenue to “pay” for anticipated tax reductions.
In order to prevent companies from shifting profits to low or no tax countries, provisions will be put in place to tax, at a reduced rate and on a global basis, the foreign profits of U.S. multinational corporations. In addition, new rules will be enacted to “level the playing field” between U.S.-headquartered parent companies and foreign-headquartered parent companies.
As previously mentioned, the framework described above is just the beginning. Congress will have to put together—and pass— detailed legislation before any of these proposals can be enacted into law. Recent events indicate that agreement may not come easily.
That said, tax planning in the fourth quarter of 2017 remains a necessity in order to attempt to control tax obligations. Traditional planning, such as accelerating deductions while delaying income, may become especially valuable this year, with lower future tax rates and the elimination of certain deductions a possibility.
Just to mention some examples, it may be advantageous to schedule elective medical procedures in 2017 if those outlays will qualify for a tax deduction. Prepayment of state and local taxes by December 31 would also be tax-effective, depending on your AMT situation.
In short, careful tax planning can pay off but broad generalizations as to what steps to take are hard to come by at this stage of the process. As the year goes on and actual tax legislation moves forward, and we have a better understanding of what could be enacted, it will become increasingly important for you to schedule tax planning meetings with us so we can offer personalized advice.
Citrin Cooperman’s Federal Tax Policy Team
As this Trump tax plan moves through the legislative process, Citrin Cooperman’s Federal Tax Policy Team (FTPT) will continue to keep everyone abreast of the provisions contained in the actual legislation. The team will examine any new tax legislation, as it is enacted, in order to identify strategies and planning opportunities to help our clients best manage the complexities of their tax situation.