United States: Potential For Tax Reform In 2017: Insight From Proposals Of The President-Elect And Congressional Republicans

In the U.S. general election held on November 8, 2016, Donald J. Trump was elected to become the 45th President of the United States. Republicans also retained their majorities in both the U.S. House of Representatives and the U.S. Senate for the new Congress convening in January, meaning that Rep. Paul Ryan (R-WI) is likely to remain the Speaker of the House and Sen. Mitch McConnell (R-KY) is likely to remain the Majority Leader of the Senate. For the benefit of non-U.S. readers, this result means that Republicans will control of all three lawmaking bodies of the U.S. federal government, although the current rules of the Senate give Senate Democrats some limited ability to block proposals and legislation in that body.

During 2016, the President-Elect and Congressional Republicans have issued white papers outlining their respective proposals for U.S. tax reform, both of which would affect the U.S. federal taxation of individuals and businesses both domestically and internationally. It is obviously too soon to say whether, when or in what form any tax reform legislation will be advanced in the next Congress. In the ordinary course the Treasury Department would release in early 2017 the new administration's tax proposals (the "Green Book"); the Congress could introduce a bill embodying either a partial or comprehensive tax reform proposal at any time. Below is a summary of the most important elements of both tax reform proposals.

Proposals of the President-Elect

The President-Elect set forth his tax plan (the "President-Elect's Plan") on his campaign's website (https://www.donaldjtrump.com/policies/tax-plan/, last visited November 10, 2016). The President-Elect's Plan lacks the detail of an actual statute, and the proposals would seem to require considerable elaboration in the legislative process. This discussion is limited to the matters directly addressed in the plan as published – i.e., no attempt has been made to interpret whether or how any possible open issues might be resolved.

Individual Income & Estate Taxes. The President-Elect's Plan includes would reduce the top marginal rate on individuals to 33% on income over $225,000 for married couples filing jointly ($112,500 for single filers). and also proposes a flat repeal of both the current 3.8% tax on "net investment income" and the individual alternative minimum tax ("AMT"). While the President-Elect's Plan would preserve the existing maximum preference rate of 20% on capital gains, it states that "[C]arried interest will be taxed as ordinary income," without elaboration. The President-Elect's Plan would also tax income earned through flow-through entities (such as partnerships and subchapter S corporations) and reinvested in the business at the top corporate tax rate of 15%, rather than the 33% rate. However, some advisers to the President-Elect have suggested this reduced rate would not apply to the reasonable compensation of the owners (as the Congressional Republican's plan provides, as described below). The interaction of this proposal with the proposed treatment of "carried interest" as ordinary income is not entirely clear.

The President-Elect's Plan would simplify deductions for individuals, raising the standard deduction but eliminating personal exemptions, and capping itemized deductions at $200,000 for married couples filing jointly ($100,000 for single filers). Under current law these deductions include state and local income, real estate and certain other taxes paid; mortgage and investment interest: medical expenses subject to a floor; charitable contributions; casualty and theft losses; unreimbursed employee expenses; and miscellaneous other deductions subject to a floor.

The President-Elect's Plan would repeal the estate tax, but provides that "capital gains held until death and valued over $10 million will be subject to tax." The proposal implies that appreciated property bequeathed to charities would not be subject to the capital gains tax, unless it is bequeathed to a private foundation established by the decedent or the decedent's relatives.

The President-Elect's Plan also contains a variety of proposals for individuals relating to child and dependent care which are likely to be of substantial interest to lower-income taxpayers.

Business Taxes. The President-Elect's Plan would lower the top marginal corporate income tax rate from 35% to 15%, and eliminate the corporate AMT. However, this reduced rate appears to be limited to retained (rather than distributed) earnings. If enacted, this would move the U.S. from having one of the highest corporate income tax rates in the developed world to among the lowest.

The President-Elect's Plan provides for a "deemed" repatriation of corporate profits held outside the U.S., taxed at a one-time rate of 10%.

The President-Elect's Plan would eliminate most "corporate tax expenditures" except for the existing research and development ("R&D") credit. The President Elect's Plan also would allow an election for domestic manufacturers to expense currently capital investment, broadly in exchange for forgoing the corporate interest expense deduction (which presumably would be available otherwise). The President-Elect's Plan contains additional provisions designed to encourage spending by businesses in support of childcare for employees.

Proposals of the Current Republican Congressional Majority

The House Republicans Tax Reform Task Force, led by Rep. Brady (R-TX) and under the auspices of Speaker Ryan, released The Tax Reform Task Force Blueprint (the "House Blueprint") on June 24, 2016. The House Blueprint contains a wide variety of tax reform proposals and policy justifications for each. Certain of the House Blueprint proposals are similar to those in the President-Elect's Plan, but the House Blueprint contains substantially greater detail. The House Blueprint includes business and individual tax reform proposals (discussed here), and also proposals for restructuring the Internal Revenue Service (not discussed here).

Individual Income & Estate Taxes. Like the President-Elect's Plan, the top marginal income tax rate for individuals would be reduced to 33%, but instead of maintaining the current capital gains rate system, "investment income" (defined to include capital gains, dividends and interest income) would be taxed at 50% of the otherwise applicable rate – effectively lowering the top marginal tax rate on capital gains, dividends and interest to 16.5%.

Similar to the President-Elect's Plan, a larger and simpler standard deduction would be created, eliminating personal exemptions and the AMT, and modifying credits and deductions for child and dependent care. Additionally, the House Blueprint would preserve but simplify educational tax benefits. The House Blueprint also eliminates most itemized deductions, exemptions and credits for individuals (including the deduction for state and local taxes), but would allow the mortgage interest deduction and charitable contribution deduction to be claimed in lieu of the standard deduction. The House Blueprint also generally calls for reform and simplification of the variety of retirement savings plans authorized under current law (e.g., IRAs, Roth IRAs, 401(k) plans, etc.).

The House Blueprint calls for an absolute repeal of the estate and generation-skipping transfer-taxes, apparently without exception (and without requiring the taxation of any amount of capital gains on appreciated assets held at death, as the President-Elect's Plan provides).

Business Taxes. The House Blueprint proposals broadly are divided into those affecting "small businesses" (meaning sole proprietorships and pass-through entities) and "large businesses" (meaning entities taxable as corporations). Under the House Blueprint, income on "small businesses" would be subject to a top marginal tax rate of 25%, rather than the 33% rate otherwise applicable to ordinary income. However, "owner-operators" of sole proprietorships and pass-through businesses must be paid, or will be deemed to have been paid, "reasonable compensation" by the business. Such compensation would be taxable to the individual at full ordinary rates – i.e., to a maximum of 33% – and would be deductible at the entity level, as it would be under current law.

For "large businesses," the House Blueprint would cut the top corporate tax rate to 20%, and would eliminate the corporate AMT. Similar to the President Elect's Plan, but providing additional detail, the House Blueprint would allow full, current-year expensing for new investments in tangible and intangible property (including intellectual property; the House Blueprint is silent on acquired goodwill) but not real estate.

The House Blueprint would also limit the deductibility of interest expense incurred in a trade or business to the extent of current year taxable interest income, with any remaining interest expense ("net interest expense") being eligible for an indefinite carryforward. Special rules would be developed for banks, insurance companies and leasing companies, as interest income and expense is inherent to these businesses.

Net operating losses ("NOLs") would be reformed under the House Blueprint to allow indefinite carryforwards with an inflation adjustment factor applied but no carrybacks at all. The use of carryforward NOLs in any given taxable year would be limited to 90% of the "net taxable amount" for the year without regard to the carryforward – i.e., carryforward NOLs could not offset more than 90% of a corporation's taxable income in any given year.

Finally, the House Blueprint generally would eliminate all other deductions and credits for corporations other than the R&D credit (also preserved in the President Elect's Plan), although the House Blueprint would reform the R&D credit to make it more "effective and efficient."

International Taxes. The House Blueprint proposes a "destination-basis" tax system under which the United States would tax only products consumed in the United States (rather than products produced in the United States) and a territorial tax system under which income earned abroad would be exempt from tax (replacing the current U.S. system of worldwide income taxation).

The House Blueprint asserts that the destination-basis system as proposed, taken together with the other business tax reforms in the House Blueprint, complies with existing World Trade Organization prohibitions on border adjustments for income taxes. The House Blueprint also provides for repeal of current controlled foreign corporation rules governing foreign base company sales income and foreign base company services income as unnecessary in a destination-basis system, but to prevent abuse would retain the foreign personal holding company income rules (covering various categories of passive income such as interest and certain real property and royalty income).

The territorial tax system proposed in the House Blueprint would provide for a deemed repatriation of existing offshore earnings taxable at 8.75% on earnings held in cash or cash equivalents, and 3.5% on all other earnings. The tax would be payable over an eight-year period. The House Blueprint also provides, in very general terms, that appropriate international tax reforms would be implemented to address the appropriate treatment of individuals living and working abroad.

Possibilities for Further Developments

While the President-Elect's Plan and the House Blueprint represent the most recent proposals by those who will be in control of the legislative process next January, the actual legislative text of any proposal almost certainly will contain substantial additional detail. It also seems very possible that additional proposals may be introduced in the legislative process.

Potential For Tax Reform In 2017: Insight From Proposals Of The President-Elect And Congressional Republicans

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