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Tuesday, October 17, 2017

Summary and Observations on Tax Reform Framework

On 9/27/17, the Big 6 released their tax reform framework to guide the drafting of tax reform legislation (see my 9/30 post for links). Here is my summary and observations:

9-page framework
Lots of details are missing such as where rate brackets start and end, rate on investment income, and what “loopholes” will be closed.
Standard deduction of $24K for MFJ and $12K for single
Will the head-of-household filing status continue?
Personal and dependency exemptions are removed. 
The stated deductions are almost double the current amounts.
Individual rates: 12%, 25% and 35% and perhaps a rate above that for high income individuals for progressivity.
Today, lowest bracket is 10% and highest is 39.6%.
Will there be a special rate for investment income, including today’s 0% rate that applies to some capital gains?
Where will these brackets start and end?
Child Tax Credit – phase-out limits increased; first $1K is refundable.
Non-refundable credit of $500 for non-child dependents.
Today, CTC only applies to children under age 17 while dependency might go up to age 23 (full-time student).
If all workers are to get a higher paycheck and today about 45% of individuals pay no income tax due to low income, even if they get a higher refundable child credit, it won’t affect their paycheck.
 With this change and repeal of dependency exemption, employers likely will need to get new W-4 forms from employees (and IRS needs to create the new W-4 form).
Only itemized deduction for home ownership and charitable contributions remain.
Repeal of state tax deduction can result in tax increase for many taxpayers.
Repeal of medical expense and casualty loss might adversely taxpayer’s ability to pay.
Preferences “that encourage work, higher education and retirement security” are retained.
No details provided. Is the preference that encourages work the EITC? Will education provisions and retirement plan options be streamlined and simplified?
Individual and corporate AMT repealed.
What happens to any minimum tax credit a taxpayer is carrying forward at date of enactment?
Repeal of other provisions.
What might this include?
Repeals estate and GST taxes.
What happens to basis of assets at date of death?
Will the gift tax remain?
Corporate rate is 20%.
Per the framework, the average corporate rate among industrialized countries is 22.5%.
The rate for “business income of small and family-owned businesses is 25%. There will be measures to “prevent recharacterization of personal income into business income.
Assuming there are rate cuts, less than 5% of owners would possibly even be in a rate above 25%. There are still payroll tax considerations and make it important that all non-C corporation owners distinguish services income from return on capital invested in the business.
Double taxation of corporate income might be addressed.
Senator Hatch has discussed corporate integration via a dividends paid deduction approach with withholding.
Expensing of new investments in depreciable assets other than structures, made after 9/27/17 will be expensed, at least for the first five years.
This is the only mention of a date in the framework. Will it include expensing of intangibles as well? New or also used property? Why five years only? What happens after that? The five years is likely due to the need to keep the bill revenue neutral by year 11 due to the budget reconciliation. Will temporary rather than permanent expensing adversely affect the economic growth projections? The Tax Foundation says yes (Pomerleau, “Economic and Budgetary Impact of Temporary Expensing,” 10/4/17).
Net interest expense of C corporations is “partially limited” and a similar treatment for other entities will be considered.
There are likely two rationales for limiting the interest expense deductions: (1) a revenue raiser, and (2) if assets are expensed and debt-financed, the effective tax rate is very low, perhaps even zero or negative; thus warranting a limitation on the interest expense.
§199 manufacturing deduction will be repealed.
No surprise here as this measure is really just a rate cut for many taxpayers, but added complexity.
Various unnamed tax preferences will be repealed or cut back. Only the research and low-income housing credits will remain.
The rationale for keeping the research credit is likely because other countries with a lower tax rate also have research incentives. Also, this credit exists not only for its incentive effect, but also to address the spillover effects when a company engages in R&D but others benefit from it as well.
Changes will be made to tax rules for specific industries to “better reflect economic reality” and reduce tax avoidance.
No examples are provided.
For businesses, worldwide taxation will be replaced with territorial with a 100% exemption for dividends from foreign subs (if the U.S. parent owns at least 10%). Transition rules will include deemed repatriation with a rate lower for illiquid assets than for cash and cash equivalents. Payment will be spread over several years. To prevent shifting certain income to tax havens, there will be a reduced tax rate on the foreign profits of U.S. multi-national companies
Many details are missing here including the deemed repatriation tax rate, the period for paying the tax, and what other rules will need to change due to the shift to a worldwide tax system.

The plan also states President Trump’s President Trump’s Four Principles of Tax Reform:
1.      Simple, fair, easy to understand
2.      Give American works a pay raise.
3.      Make America a jobs market of the world
4.      Bring back trillions of dollars of unrepatriated earnings.

What do you think?

Friday, October 13, 2017

Can tax reform solve more problems

The key problems that today's federal tax reform aims to resolve is to lower the corporate rate and move to a territorial system rather than worldwide to improve international competitiveness for businesses. It also calls for some level of simplification, but there aren't enough details yet to judge that. Proponents, such as the "Big 6" who released a framework on 9/27 (see xxxx post), also want to increase economic growth.

Elements of the framework to boost economic growth are the lower corporate tax rate and expensing of business assets (either for a few years or permanently). Is that the only way to boost economic growth? Can more be done? Probably.

I raise this issue after reading a proposal from Congressmen Neal and Whitehouse:

H.R. 3499, Automatic IRA Act – “to expand personal saving and retirement savings coverage by enabling employees not covered by qualifying retirement plans to save for retirement through automatic IRA arrangements, and for other purposes.”

Their  9/26/17 press release states that they project that this bill could “boost national savings by nearly $8 billion annually.”

Is there some intersection of ideas here?  Greater savings can also tie to investment in business expansion to help fund economic growth. And we know that people are not saving enough for retirement. Per the sponsors of HR 3499, about 90% of small to mid-size businesses do not offer retirement plans for their workers.

What do you think?

Thursday, October 12, 2017

Tax Reform Issues

Speaker Ryan explaining tax reform at 10/4/17 Facebook Event,
holding the postcard form (see my comment below though)
There are a lot of uncertainties in trying to fully understand tax reform with a few pages of ideas where lots of important information is missing. Don't get me wrong, tax reform is needed as our system is too complex, inequitable, inefficient and doesn't collect all of the tax owed (leaves about $385 billion uncollected annually).

On 10/10, Speaker Ryan noted 5 ways that tax reform will save people taxes in 2018. Each seems correct, but each has uncertainty connected with it because we don't have legislative language yet or hides that the framework, despite suggestions of modernization, doesn't fully modernize our tax system. Here are his five items:

1. Bigger standard deductions - He says it will be "nearly doubled." The framework indicates, for example, that the standard deduction for a single person will be $12,000. It is $6,300 today. What he doesn't say though is that the personal and dependency exemptions go away. Today, that's $4,050 per person. While the child credit is supposed to increase and apply to more families, today, it only applies to children under age 17 while the dependency exemption can cover some children up to age 23. So, not enough details yet to indicate that any individual paying income tax today will see lower income taxes in 2018, particularly if they have a few children and lose itemized deductions that would have been larger than the new standard deduction.

2. Lower individual rates - The framework suggests rates of 12%, 25% and 35% and perhaps a higher rate for high income individuals. Today, the lowest rate is 10%.  Actually, the lowest rate today and under the plan is 0%. If someone today has income too low to pay income taxes, that should continue under the framework. These folks - about 45% of individual filers, won't see bigger paychecks. There is no talk of lowering the 15.3% payroll tax. Some of these zero bracket filers might be getting a larger refundable child credit, but they won't see that until they file their tax return. Also, we don't know where the rate brackets start and end so we don't know for sure if everyone drops income into lower rates.

3. Capped rate on small business of 25% - Leading up to the release of the framework, there was talk that this would not apply to all businesses and perhaps some personal services, such as accounting, would not get the cap. Again, depending on where the individual rates start and end, most small business owners should not be in the 35% rate because they are not today. [TaxProToday, 9/13/17]

4. Immediate write-offs for business investments - The framework suggests allowing expensing of capital investments. Ideally, this would also include intangibles and both acquisition of new and used depreciable property.  Details are missing.

5. Increased child tax credit - Apparently, this is to adjust for repeal of the dependency exemption. The dependency exemption though can apply to more than your child. Also, the current child credit covers a narrower age range than the dependency exemption.

Speaker Ryan also notes that if compliance costs go down, that is also a tax cut. I'm not sure we'll see a significant drop in compliance costs. There are still complexities such as the child tax credit and hopefully, the Earned Income Tax Credit remains. Promotion of IRS VITA sites and other low-income tax preparation clinics would help keep compliance costs down for many.

Caution - A postcard size return doesn't say anything about the complexity level of a system. We could file on postcards today if the IRS would take less information on the components of our taxable income. The postcard in the Republican blueprint of June 2016 didn't have a place to sign or a penalty of perjury statement or information about the taxpayer or where to deposit any refund.  AND, why are we modernizing our tax system to fit on a postcard rather than to use today's technology to not even have to file for most people because the system already has enough information to just sent a bill or deposit the overpaid taxes in your account or send you a secure debit card?

There is a lot of good about tax reform and it would be good to hear more about that rather than claims that don't seem completely accurate or complete.  And there is a lot of information often missing such as the effect on the deficit and debt, distribution of the tax cuts among different income levels, transition, timing, and more. Speaker Ryan's 10/10 post includes a video of him explaining the tax system and notes many good ideas, we just need to be critical listeners and watch for missing pieces.

What do you think?

Note: These views are mine and not necessarily those of my employer or any organization I'm involved with.

Saturday, September 30, 2017

Tax Reform Framework Observations

Press conference on release of tax reform framework on 9/27/17
On September 27, the "Big 6"* released their tax reform framework. It doesn't add much more than we have known for the past 16 months other than:
  • Top corporate rate is 20% rather than President Trump's 15%. The 20% rate should help us be more competitive internationally, particularly along with a shift from a worldwide system to a territorial one (15% would be better, other than for the budget effect).
  • The individual brackets will be 12%, 25% and 35% and perhaps something higher than 35%. In April, President Trump suggested 10%, 25% and 35% while last June the House Republicans suggested 12%, 25% and 33%. Today's lowest bracket (other than zero) is 10%. Seems odd to try to sell tax cuts with a higher lowest rate, but the effect also depends on where the brackets start and end and a few other provisions.
There are lots of cautions to exercise in dealing with this brief framework:
  • There is a lot missing such as where individual tax brackets start and end, whether the head-of-household filing status will be repealed (it is not mentioned in the framework), what "additional tax relief" will be provided "during the committee process," the rate that applies to capital gains and other investment income, and whether interest expense of businesses operating as other than C corporations will be limited.
  • While the standard deduction will be doubled, the personal exemptions and additional standard deduction (for age and blind) are removed. So, for example, today, a single person has a personal exemption of $4,050 and standard deduction of $6,300 for a total of $10,350. Doubling the standard deduction to $12,000 and removing the exemption means an increased deduction of $1,650 rather than $6,300.
  • The dependency exemption is removed and replaced with a "significantly" larger child tax credit but it doesn't say how much higher.  Also, the child tax credit is for children under age 17 while the dependency exemption covers up to age 23 and perhaps even higher in some instances.
  • A more accurate measure of inflation will be used to adjust brackets, the standard deduction and phase-outs. This makes sense but does mean that future adjustments will be less than we have today (this is a revenue raising provision).
  • Will repeal of the estate tax also include repeal of the step-up (or down) in basis at date of death or similar measure to ensure that gains at death don't escape both the estate tax and the income tax which would be a tremendous benefit to wealthy individuals?
Another big caution - don't believe everything you hear. For example, when President Trump announced the framework while in Indiana, he noted that it would not help him, implying that it helps the middle class (see Washington Post article of 9/27/17).  Not true at all.  The rate cut helps him. Also, he likely holds his vast business operations in many different types of entities including partnerships and S corporations and will benefit from the top rate of 25% on such income even after paying himself reasonable compensation. Also, if he is still carrying forward a net operating loss, repeal of the AMT helps him. And repeal of the estate tax is a tremendous tax cut for him. The Tax Policy Center's analysis of the framework indicates that about 75% of the tax benefits of the framework go to the top 25% of income earners in 2018 and 87% by 2027, with the top 1% benefiting the most. Of course, due to missing details, they had to make some assumptions, such as where the individual brackets start and end.

Speaker Ryan says many individuals will have a postcard size tax return - unlikely but perhaps shorter. But why are we talking about fitting a 21st century tax system on a postcard return rather than having a just-in-time filing system?

And, we don't have a cost estimate - will the plan raise or lower revenue. Most likely it will lose revenue (the framework is almost all tax cuts rather than noting many revenue raisers). The Senate budget plan includes $1.5 trillion over the next ten years for tax reform - meaning that it is okay to lose $1.5 trillion. The Committee for a Responsible Federal Budget estimates that that framework might lose $2.2 trillion over ten years ($2.7 trillion when interest on the new borrowing is included). Also, how will any tax reductions for low and middle-income individuals compare to increased health insurance and health care costs due to weaknesses in the Affordable Care Act and the costly income exclusion for employer-provided health insurance that are not addressed?

And, when will we see details? Speaker Ryan has suggested we'll have a new tax system before 2018. Let's see. There is still a lot of work to figure out the details, draft the legislative language, hold hearings, and gain support of both parties (the framework indicates that bipartisan support and participation is encouraged). All possible, we'll see.

What do you think?

*Mnuchin, Cohn, Brady, Hatch, McConnell and Ryan

Monday, September 25, 2017

Who should get a rate cut in tax reform?

For the past few years, the focus of federal tax reform has been on reducing the corporate statutory rate from 35% down to 25% (H.R. 1 (113rd Congress, Camp)), 20% (House Republican blueprint of June 2016) or 15% (Trump 1-pager). The rationale for a corporate rate cut is that ever since we last reduced the top corporate rate from 46% to 34% with the Tax Reform Act of 1986, other industrialized countries did the same (in 1993 the rate was increased to 35%). You can see from this OECD data that most countries have a lower rate, although France is at 34.43%.

Most businesses don't operate as C corporations. Instead, they operate as sole proprietors, partnerships, LLCs and S corporations. For these entities, the income mostly is taxed at the individual tax rates where the top rate is 39.6% although less than half of one percent of individuals are in that top bracket. According to a recent report from the Joint Committee on Taxation (JCT), for 2016, it is estimated that only 6% of individual returns report income of $200,000 or more. For married taxpayers filing jointly, at $200,000 of taxable income, about $45,000 of that income is taxed at 28%. They would need to have over $233,350 in 2016 to get to a 33% marginal tax rate, over $415,700 to get to a 35% marginal rate and over $470,700 to reach a 39.6% marginal rate.  If their income consists of capital gain income, it is taxed at 0% and 15% and doesn't reach 20% until income exceeds $470,700. Basically, very few individuals are at today's top individual rates although many who are have a lot of income.

JCT, JCX-42-17 (9/15/17)
Should only C corporations get a rate cut? I don't think so.  If the goal of lowering rates is to improve competitiveness, than it makes sense to lower rates for all entities. Also, if only the C corporation rate is lowered, some other types of entities might find it advantageous to convert to the C corp form despite double taxation of corporate income (once by the corporation and again by the shareholders when a dividend it issued).

Recently, Treasury Secretary Mnuchin stated that accounting firms would not get a lower rate even if the rate is reduced for non-C corp entities. He implied that only firms creating manufacturing jobs would justify a rate cut. (Bloomberg, "Trump Officials Temper Expectation of 15% Corporate Tax Rate," by Mohsin and Sink, 9/12/17.) Wow! The government produces lots of data, but I'm concerned that not many policy makers look at it.  According to the Bureau of Labor Statistics, accounting jobs are growing faster than for other industries - at an 11% rate. And these are good paying, interesting jobs that are key to business growth overall. In contrast, jobs for fabricators and assemblers are declining by 1%.

Barry Melancon, President and CEO, has a blog post on Secretary Mnuchin's comments and the justification for lowering all business tax rates as part of reform - check it out. Also see this AICPA testimony for the Senate Finance Committee's hearing of 9/19/17 on business tax reform.

Note: For the rate cut for non-C corporations, the owners must first pay themselves reasonable compensation to be taxed at individual rates + payroll taxes. The remaining income would be taxed at a lower top rate than other individual income though.

What do you think?