United States: Trump's Tax Plan

Last Updated: December 19 2016
Article by Stanley Rose

President-Elect Donald Trump's surprise victory last month has generated significant interest in his vision for how tax reform will help, to borrow from his campaign theme, Make America Great Again. The unexpected speed with which he is filling his cabinet, the Republican control over both the House and the Senate, and the many similarities between his plan and one proposed earlier this year by House Republicans all serve as indicators that he has the resolve and potentially the means to follow through with his vision.

Trump's tax plans are housed on his website, and while portions are provided in detail, others are somewhat general or even vague, leaving us to interpret their meaning and speculate their impact. The plans also have been changed more than once since they were first rolled out during the campaign, and undoubtedly will change again. The purpose of this article is to share an overview and analysis of his tax plans based on the current information available.

Executive summary

  • Due to potentially lower rates and reduced deductions applying next year, consider deferring income to next year and accelerating deductions into this year.
  • The proposed 20% capital gain tax will apply at lower income levels than the 15% capital gain tax applies this year, and those who are in the 15% bracket may want to trigger gains this year.
  • Charitable contributions may be worth more in 2016 than under the Trump plan. Taxpayers may want to establish a donor advised fund this month to maximize their deductions and preserve the ability to identify the ultimate donee at a future date.
  • Taxpayers subject to the AMT (alternative minimum tax) in 2016 may want to defer expenditures that are not deductible under AMT rules until 2017. Common examples include miscellaneous itemized deductions and state/local income taxes.
  • Owners of pass-through entities may need to alter how they compensate themselves, because wages and guaranteed payments could be subject to higher taxes than pass-through income under Trump plans. Owners who fund significant income tax payments via withholding from wages may need to shift to use of quarterly estimates.
  • If capital gains, instead of estate values, are taxed at death, estate planning could be replaced with capital gain planning and existing estate plans will need to be completely overhauled.
  • Taxpayers involved with a pending asset sale that will close this year should consider deferring payment until next year. At that time, they can decide whether to defer gain and pay taxes at potentially lower 2017 rates, or elect out of installment treatment and pay tax applicable to 2016.

Civics 101

Trump's plans are ambitious, and while Republicans will control the White House and both chambers of Congress, proposed laws have a significant, multi-step gauntlet to survive before they see the light of day. Let's briefly discuss the process by which federal tax laws are made, so you can see through the partisan bickering on which the media will focus and understand the true progress of these proposals in the weeks and months to follow.

Procedurally, legislation begins in the House as a bill, addressed first by the Ways and Means Committee, before being introduced to the full House. The Senate, through its Finance Committee, uses the House version as a starting point but modifies the bill (often substantially) before introducing it to the full Senate. In the rare event that the House version survives the Senate unscathed, it heads to the President. More often, a Conference Committee is formed with members of the House and the Senate to iron out the differences before it advances back through the House and Senate before going to the President. Although the House technically is responsible for initiating the process, it is common for the President to draft proposed legislation and send it to the House via a sponsor to start the process.

Observation: It comes as no surprise that Trump's plans include significant tax cuts for most categories of taxpayers. But the national debt has climbed fast and high under the current administration and is now close to $20 trillion. This suggests a few things: First, Trump's plans will be given more of his own team's scrutiny since it is now clear much of it seems destined to become law. (He already has revised the plans he rolled out last year, including an increase to the individual tax rates that he previously had proposed.) Second, his plans are likely to be tempered a bit by Congress (even a Republican-controlled Congress), which will not want the national debt to balloon under their relatively unfettered watch. Third, even with one party controlling the process, an overhaul as large as proposed is not likely to be finalized for several months. Tax laws involve far more than revenue-raising; they are riddled with social goals. Special interest groups that have the ear of both parties will weigh in during this process, and members of Congress (theoretically) answer to their constituents rather than the President and their party leaders.

Individual income taxation

Rates

There currently are seven individual tax rates ranging from 10% to 39.6%. Trump's plan instead contains three: 12%, 25% and 33%.

The favorable rates provided for long-term capital gains and qualifying dividends will be retained, with such income taxed at 0% for those in the new 12% ordinary income bracket; 15% for those in the 25% bracket, and 20% for those in the 33% bracket.

The alternative minimum tax ("AMT") will be repealed. The 3.8% net investment income tax (which was created to help fund "Obamacare") also will be repealed.

"Carried interest" will no longer qualify for favorable tax rates.

Observation: As explained below, a new tax rate of 15% is proposed for pass-through income, so unless a carve-out is implemented, carried interest may not be subject to an increased rate for all taxpayers.

Deductions/credits

While most taxpayers will enjoy lower rates, many will see fewer deductions than currently exist – especially those in the upper brackets. For instance, exemptions will be collapsed into standard deductions, with a combined amount of $15,000 for single filers or $30,000 for joint filers. Head of household status will disappear. Those who opt instead for itemized deductions will see them capped at $100,000 for single filers and $200,000 for joint filers. In exchange for the lower rates, many unnamed deductions are described as "unnecessary or redundant." We are told that charitable contributions and mortgage interest deductions will "remain unchanged for all taxpayers," but it is unclear whether or not these items are subject to the overall cap. Childcare costs will be deductible in arriving at AGI, capped at the average cost of care in the taxpayer's state. This deduction is phased out for single and married taxpayers with incomes of $250,000 or $500,000, respectively.

The Earned Income Credit will be expanded for low-income taxpayers to provide up to $1,200 in rebates toward child care.

Observations: With joint numbers set at exactly double the single amounts across these proposals, Trump will dismantle the "marriage tax penalty." Also, because it is unclear whether charitable contributions will be subject to the overall caps described above, last-minute 2016 contributions, if deductible under current rules, should be considered. Donor-advised funds may be established this year that provide 2016 deductions, but preserve the ability of the donor to direct ultimate disposition of the funds at a later date.

Business income taxation

Rates

Let's review current business taxation before discussing how it will change. Oversimplifying a bit, business income today is taxed under one of two regimes: 1. C-corporations and 2. all other businesses, including S-corporations, partnerships, LLCs and sole proprietorships.

  1. C-corporations currently are taxed at the entity level, at effective rates ranging from 15% to 35%. An alternative minimum tax ("AMT") might instead apply at 20%, using a different income base, but only if higher than the regular tax. In either case, when dividends from those corporations are paid to shareholders, the individual shareholders pay tax (a second tax) on that dividend income – generally at 20%.
  2. Pass-through entities (S-corporations, partnerships and LLCs) generally are not taxed at the entity level at all. Instead, entity income is deemed to have "passed through" to the owners and is taxed on their returns at whatever rates apply to those owners – even if that income is not actually distributed to them. However, when that entity's income is later distributed to the owners, the owners generally (there are exceptions) do not have to pay a second tax on those "dividends." Sole proprietor income is taxed at the individual level as well.

Trump plans to cut the corporate rate to 15% (down from a top rate of 35%), and eliminate the AMT. However, his plans for pass-through entities ("PTEs") are much less clear. He appears poised to tax all businesses under one regime, regardless of business form, and if so, this represents a very significant change. When contrasting with C-corporations, he notes that "freelancers, sole proprietors, unincorporated small business and pass-through entities are taxed at the high personal income tax rates." For them, he proposes a "new business income tax rate within the personal income tax code that matches the corporate tax rate ..." His website notes that the new 15% rate will be available "to all businesses, both small and large, that want to retain the profits within the business."

Observation: Some have speculated that Trump plans to subject PTEs to the second layer of taxation applicable to C-corporations. If so, entities may consider making nontaxable S-corporation, LLC or partnership distributions now, but we simply do not have sufficient information to know if this speculation is correct.
Another observation: S-corporation owner/employees generally draw wages from the same entities that produce pass-through income for them, and many (especially 100% owners) fund the lion's share of their taxes via large, end of year bonuses that contain significant income tax withholding. Wages and most pass-through income are subject to tax at ordinary rates. If wages soon will be taxed at a higher rate than pass-through income, tax advisors will quickly begin suggesting that wages not be used as a vehicle for funding significant taxes. These shareholders should consider changing their ways as early as April of 2017, by making a Q1 2017 tax payment. We will be watching as this develops, as it represents not only a potential change, but a significant planning opportunity.
Another observation: Pass-through income currently includes various categories of income that are taxed differently to their owners. For instance, an S-corporation may produce ordinary income that is taxed based on that taxpayer's bracket, and also produce long-term gain that is taxed at 20%. Will this continue? If not, gains produced by an S-corporation may be taxed to some shareholders at a lower rate than they are now.
Yet another observation: The attempt to eliminate differences in tax between types of business income is clear in the Trump plan, but no mention is made of one significant existing difference – self-employment income. This tax, including Medicare tax, currently applies to sole proprietor income and owner/employees of LLCs and partnerships – people who are actively employed by their own businesses. But it does not apply to flow-through income of S corporations, even for owner/employees. Passive investors in all pass-through entities, at certain income levels, are subject to some Obamacare provisions that assess a tax that mimics the Medicare portion of payroll tax. Collectively this means that current rules favor active S corporation employee/owners as the only parties immunized from such taxes. If Obamacare tax provisions are revoked as Trump has promised, passive S corporation owners will join them, and S corporations may stand out as a preferable form of business for both active and passive investors.

Deductions/credits

The rates are not the only aspect of business taxes affected; the President-elect also has plans for a few business deductions and credits.

Significantly, businesses will have a choice – capital investments can be immediately deducted, but only for taxpayers willing to forgo interest expense.

Observation: This one hurts. Just a year ago, we finally saw the current Section 179 deductions made permanent after years of on again, off again expirations and renewals, and any reasonable interpretation of the Trump plan impacts the Section 179 deduction (and bonus depreciation). This rule also is confusing. Details are very sparse, but presumably a taxpayer who does not immediately deduct capital costs may instead depreciate those costs over the assets' tax lives and deduct interest, meaning both deductions are preserved in exchange for one of them being delayed. By contrast, election of the immediate capital deduction apparently produces a permanent loss of interest deductions, which seems short-sighted and ill-advised under nearly every possible scenario. Also, it is unclear whether the interest in question consists of all interest paid by the taxpayer, or merely interest incurred to finance (or somehow otherwise linked to) the related asset purchase. If the latter is true, this will create a tracing nightmare. Some loans (car loans or business acquisitions, for example) are clearly linked to specific assets, but most commercial loans and lines of credit are not. The complexities involved with implementing this proposal could be significant.

The existing Section 199 Domestic Production Activities Deduction ("DPAD"), which provides an additional 9% deduction for many manufacturing and similar costs, will be retired.

Most business "expenditures" other than the research credit, will be eliminated.

Observation: "Deductions" or "credits" would be much more useful terms than "expenditures," as this language could be construed to mean an end to many deductions. However, in context, it appears to refer to credits. Otherwise the need to address several specific deductions separately (as Trump has done) would not exist. This ambiguity, though, drives home the importance of not dwelling too much on the wording in the plans until they are tightened up and reduced to a bill.

International

Trump's plan calls for a one-time, deemed repatriation of corporate cash held overseas, to be taxed at 10%. Because it is a deemed repatriation, money can be left overseas, but cannot escape the current taxation. Going forward, the same appears to be true, as the plan (without many details) calls for an "end of the deferral of taxes on corporate income earned abroad." The foreign tax credit will survive, however, preventing double-taxation. Collectively, these changes will render corporate inversions (the subject of much press in recent years) nearly useless as a tax-planning move.

Observation: One would assume that a tax on un-repatriated earnings would be phased in over time, but the planned timing of this assessment is unclear.

Death of the death tax

The Trump plan calls for the end of the federal estate and gift tax. However, an interesting concept takes its place. If an estate's assets include unrealized capital gains of $5 million or more, those gains will be subject to income tax as capital gains at that time. The overall value of the estate will not be a factor in determining taxability; this tax is based on capital gains that have not been taxed during the decedent's life. The campaign also has proposed a ban on contributing appreciated assets to a private family charity to circumvent this capital gain tax.

Observation: Trump's plan apparently eliminates the "step-up" in basis to fair market value that currently is enjoyed (often tax-free) by estate beneficiaries. His plan instead preserves the unrealized gain and passes it on to those who inherit the property. Beneficiaries will be more likely to pay income tax as the inheritance is cashed in, even for assets distributed from relatively small estates.
Another observation: The estate tax and gift tax systems currently are strongly linked. Unless the capital gain tax described above is also imposed upon gifts, it apparently can be completely circumvented simply by giving away assets prior to death. This disparity seems likely to be addressed in some manner. If not, it will be referenced by many dictionaries under the definition of "loophole."

Conclusion

President-elect Trump, his campaign spokespeople, and most recently his choice for Treasury Secretary, Steven Mnuchin, have described Trump's plan as the largest tax cuts since the Reagan years. With so many deductions on the chopping block, that remains to be seen, but that description seems accurate based on the information available today. House Republicans have developed their own plan and are in ongoing discussions with Trump's team regarding how to reconcile them, but they share many similarities, suggesting that many characteristics described above will appear in the finalized version. If history is a guide, nothing will be complete for several months, but the rules potentially will be retroactive to January 1, 2017. Some unintended consequences and confusing results already seem apparent, and while many of them will be corrected before completion, others will take their places. I'll remind readers again that the proposals described above are nowhere near being finalized, and the related interpretation and analysis involved a murkier-than-usual crystal ball. We will know more in the weeks and months that follow, and will of course update you accordingly. In the meantime, buckle your chinstraps. It should be an interesting ride.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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