With the election of Donald Trump, who pledged during the campaign to usher in fundamental tax reform (including major tax cuts), the Republican majorities in Congress have begun planning major tax changes to the Internal Revenue Code of 1986 (the "Code"). It is widely anticipated that 2017 will see the most comprehensive changes to the Code since 1986. The legislation likely will include significant cuts in federal tax rates applicable to corporations and individuals. Additionally, there will likely be significant changes to the taxation of US persons upon the receipt of future earnings generated by non-US subsidiaries and non—US branches and a potential one—time, reduced tax on prior accumulations of non—US earnings. These fundamental changes in the taxation of business income would have a meaningful impact on the way US businesses operate globally.
While it is too early to predict the precise legislative proposals, and what will ultimately be enacted, clues for possible tax changes are contained in (i) proposals made on the Trump campaign's website (the "Trump Proposal"), and (ii) reforms proposed in the House Republicans' tax reform blueprint published in the report titled "A Better Way: Our Vision for a Confident America" (the "Blueprint").
This publication summarizes some of the most significant changes contained in the Trump Proposal and the Blueprint. Future publications will update specific legislative proposals as they become more concrete, and will provide more in-depth analysis of the aspects and potential consequences of such proposals.
Corporate Tax Rates
- The Trump Proposal would reduce the highest corporate income tax rate from 35 percent to 15 percent.
- The Blueprint would reduce the highest corporate income tax rate to 20 percent.
- Both the Trump Proposal and the Blueprint would repeal the corporate alternative minimum tax.
Immediate Expensing of Capital Investment
- Under the Trump Proposal, companies engaged in manufacturing in the United States may elect to immediately expense capital investments. However, such electing companies would be required to forego the deduction for interest expense. An election to expense once made would only be revocable within the first 3 years of the election. If revoked, returns for prior years would need to be amended to show revised status.
- Under the Blueprint, the cost of capital investment would be fully and immediately deductible rather than being subject to depreciation deductions taken over time. Unlike the Trump Proposal, the immediate expensing of capital investment would be automatic, and a taxpayer would not be required to make an election in order to expense the cost of capital investment. Such expensing would be available for all business investment (including buildings, tangible and intangible assets), other than land. The intended effect of immediate expensing would be to transform the US tax system for businesses from an income tax to a cash-flow or consumption-based tax.
- The Blueprint would also disallow deductions for net interest expense. One motivation for doing so is to equalize the tax treatment of debt and equity financing. Unspecified special rules would apply to financial services companies such as banks, insurance companies and leasing companies.
Domestic Production Activities Deduction & Tax Credits
- Under the Trump Proposal, most credits and the domestic production activities deduction would be eliminated. However, the Trump Proposal would not eliminate the research and development credit.
- Under the Blueprint, tax deductions and credits applicable to "special interests" would be repealed, other than a credit for research and development conducted in the United States.
Net Operating Losses
- Under the Blueprint, net operating losses would be carried forward indefinitely (but not carried back) and increased by an interest factor. A net operating loss carryforward could be used to offset only 90% of taxable income determined before the carryforward. The Trump Proposal does not discuss the treatment of net operating loss carryforwards.
Deemed Repatriation of Offshore Cash
- The Trump Proposal would impose a one-time deemed repatriation tax of 10 percent on corporate earnings held abroad, which would be payable over a 10-year period.
- Under the Blueprint, existing offshore earnings held in cash and cash equivalents would be subject to an immediate 8.75% tax, and earnings held in other forms would be taxed at a 3.5% rate, which in each case would be payable over an 8-year.
Prospective Taxation of Foreign Income
- A prior tax reform plan released by President-Elect Trump's campaign in 2015 proposed to tax future profits of foreign subsidiaries of US companies as the profits are earned. The current Trump Proposal does not address this point.
- Under the Blueprint, the United States would prospectively apply a "territorial system," meaning that distributions from foreign subsidiaries and income earned through foreign branches would be exempt from US tax and foreign tax credits would be disallowed. Additionally, the CFC anti-deferral rules would be streamlined to apply only to passive income (foreign personal holding company income). The subpart F rules for various types of "foreign base company income" would no longer apply.
- The Blueprint would also introduce border adjustments to the taxation of products, services and intangibles that are imported into or exported from the United States. The border adjustments would be intended to mimic the border adjustments applied by other jurisdictions to value-added taxes, on the theory that the revised US business tax would apply on a cash-flow basis and therefore would be comparable to a value-added tax. Border adjustments would rebate US tax on items exported from the United States and impose US tax on items imported into the United States. These adjustments would eliminate US tax on products, services and intangibles produced in the United States, meaning such items would be taxed only by the jurisdiction where they are consumed.
TAXATION OF PROPRIETORSHIPS AND PASS-THROUGH ENTITIES
Tax Rates of Income Generated by Pass-Through Entities
- Under the Trump Proposal, business income would be taxed at a 15 percent rate. The Trump Proposal states that this rate would be "available to all businesses, both big and small that want to retain the profits within the business."
- It is unclear whether the 15 percent rate would also apply to income of pass-through entities, as some sources have reported based on the reference to small businesses, or whether the 15 percent rate would only be available to entities that elect to incorporate, with income of a partnership or S-corporation being taxed at the maximum 33 percent rate.
- Under the Blueprint, active business income earned by small businesses, sole proprietorships, and other pass-through businesses (including partnerships, limited liability companies, and S-corporations) would be taxed at a maximum rate of 25 percent. However, as discussed below, such businesses would be required to pay reasonable compensation to service provider owners, which would offset the tax benefit of the reduced rate of tax on such income (provided the service provider's individual tax rate is greater than 25 percent).
- Although the tax rate applicable to corporations would be 5 percent less than the tax rate applicable to sole proprietorships and other pass-through entities, after taking into account the 16.5 percent individual income tax rate on corporate dividends, the overall effective tax rate applicable to sole proprietorships and pass-through entities would still be lower.
- Further, it is unclear whether large S-corporations or partnerships would be eligible for the 25 percent tax rate on active business income or whether this would be limited to small businesses.
Taxation of Carried Interest
- Under the Trump Proposal, carried interest would be taxed as ordinary compensation income (at a top marginal rate of 33 percent).
- The Blueprint is silent as to whether carried interest would be taxed as ordinary income or continue to retain the character of the income generating the carry.
Reasonable Compensation Requirement
- Under the Blueprint, sole proprietorships and pass-through entities, including S-corporations and partnerships, would be required to pay reasonable compensation to their owners or sole proprietors (which would be taxable as compensation income). The Trump Proposal does not contain a similar requirement.
- Since the compensation payment would be deductible by the business, the compensation may actually reduce the overall tax burden on the owner or sole proprietor to the extent that the owner or sole proprietor's individual tax rate is less than 25 percent. However, the benefit of the 25 percent tax rate would be reduced if the owner or sole proprietor is taxed at a 33 percent rate.
- It is unclear how the IRS would apply the reasonable compensation requirement, particularly in the context of businesses generating income from the provision of services.
Ordinary Income Tax Rates
- Under the Trump Proposal and the Blueprint, there would be three tax brackets on ordinary income: 12 percent, 25 percent and 33 percent. For married persons filing jointly, the Trump Proposal would apply the top tax rate to income over $225,000, while for single persons the proposal would apply the top tax rate to income over $112,500.
Capital Gains Tax Rates
- Under the Trump Proposal, there would be three tax brackets on capital gains: 0 percent, 15 percent and 20 percent.
- Under the Blueprint, a 50 percent deduction would be available upon the receipt of net capital gains, dividends and interest income, producing rates of 16.5 percent, 12.5 percent and 6 percent on that investment income, depending on the individual's tax bracket.
Net Investment Income Tax
- Both the Trump Proposal and the Blueprint would eliminate the 3.8 percent net investment income tax.
Alternative Minimum Tax
- Both the Trump Proposal and the Blueprint would eliminate the individual alternative minimum tax.
- Under the Trump Proposal, the standard deduction would be increased from $6,300 to $15,000 for single persons and from $12,600 to $30,000 for married couples filing jointly, and personal exemptions would be eliminated.
- Under the Blueprint, the standard deduction would be increased from $6,300 to $12,000 for single persons ($18,000 for single individuals with a child in the household) and would be increased from $12,600 to $24,000 for married couples filing jointly, and personal exemptions would be eliminated.
- The Trump Proposal would cap itemized deductions at $100,000 for single filers and $200,000 for married couples filing jointly. Such a cap would severely limit the benefit of charitable deductions. Therefore, individuals may wish to consider accelerating large charitable contributions in 2016.
- Under the Blueprint, all itemized deductions would be eliminated other than those for mortgage interest and charitable donations.
ESTATE & GIFT TAX
- Under the Trump Proposal and the Blueprint, the estate tax would be eliminated.
Gift & Generation-Skipping Transfer Tax3>
- It is not clear whether the Trump Proposal would repeal the gift tax and the generation-skipping transfer tax.
- The Blueprint proposes to eliminate the generation-skipping transfer tax. However, it is unclear whether the Blueprint would repeal the gift tax.
- Until there is greater clarity on both proposals, we would advise against any transfers that would incur a material gift or generation-skipping transfer tax.
Contributions to Private Foundations
- The Trump Proposal provides that "contributions of appreciated assets into a private charity established by the decedent or the decedent's relatives will be disallowed." It is unclear what "disallowance" means in this context and whether this disallowance will apply only on death or also to lifetime transfers.
- Individuals planning to make significant gifts of appreciated property to their private foundations in the near future, you may want to consider accelerating such gifts into 2016.
- The Blueprint does not address the tax treatment of transfers of appreciated property to private charities established by a decedent or the decedent's relatives.
"Step-up" in Tax Basis, Tax on Unrealized Appreciation
- Although not entirely clear, the Trump Proposal would eliminate the current "step-up" in the tax basis of assets held by a decedent at the time of death and would tax unrecognized capital gains held by a decedent at the time of death in excess of$10 million.
- The Blueprint does not address whether assets held by a decedent at the time of its death will continue to "stepped-up" to their respective fair market values at the time of the decedent's death.
Proposed Valuation Regulations
- As we advised in a Client Publication in August, the IRS issued proposed regulations targeted at reducing or eliminating minority and marketability discounts for transfers of interests in family-controlled entities. Many clients were considering transfers by year-end or early in 2017 in order to take advantage of existing valuation rules. However, given the results of the election, we believe it is very unlikely that the proposed regulations will be finalized during the next Congress. It is our view that it is unnecessary to immediately complete a transaction due to a concern that the proposed regulations will become effective in the near term.
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.