Authored by Paul Dillon, Michelle Hobbs and Michael Wronsky
GOP congressional leaders and the White House have announced the tax reform framework that has been agreed to by the “Big Six” negotiators. The Big Six comprises Speaker of the House Paul Ryan, House Ways and Means Committee Chair Kevin Brady, Senate Finance Committee Chair Orrin Hatch, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn.
The tax-writing committees in both the House (Ways and Means) and the Senate (Finance) are expected to use the framework as their guide in crafting legislation. The framework is short on specifics; instead, it outlines principles to be included in subsequent legislation. Sen. Hatch said his committee will regard the document as a guide, but his panel will not be bound by it.
Key changes in the framework include:
Business tax rate. The current corporate tax rate would be reduced to 20 percent from 35 percent. The corporate alternative minimum tax (AMT) would be repealed as part of the rate reduction package. However, the framework sets a higher rate of 25 percent for sole proprietorships and pass-through businesses. In addition, it is widely expected that some type of reasonable compensation rules will be included with the lower rate applicable to pass-through entities. Defining reasonable compensation may prove extremely difficult as previous attempts to quantify this area of law have proved unsuccessful. Expect much debate on the pass-through rate and related rule structure.
Repatriation. An estimated $2.6 trillion in corporate profits is currently parked abroad to avoid the U.S. corporate income tax. The framework calls for a one-time repatriation of those profits to be paid over “a number of years.” The framework does not specify a rate. Previously, the House blueprint called for repatriation of foreign earnings accumulated under the current system to be taxed at a rate of 8.75 percent to the extent held in cash or cash equivalents; 3.5 percent if held in other noncash investments. The administration has been advocating a rate of 10 percent. Determination of both the rates and timeline for payment are open for the tax-writing committees to address. Repatriation is also coupled with a transition from a worldwide system of international tax to a territorial system. Further, the tax-writing committees are instructed to include rules protecting the U.S. tax base by taxing the foreign profits of U.S. multinational corporations.
Research and development (R&D) and low income housing. Speculation has been mounting as to whether R&D and low income housing incentives would be retained. The framework calls for these to be preserved while other business credits may be retained to the extent budget limitations allow.
Direct write-off of capital investment. Full expensing of capital investment, other than land and structures, made after Sept. 27, 2017, is provided for at least five years.
Business interest. The deduction for net interest expense for C corporations would be partially limited. No further details are included in the framework. Tax committees are also instructed to look at limitations for interest paid by noncorporate taxpayers.
IRC 199 manufacturing deduction. This deduction is deemed no longer necessary due to the lowering of the tax rate on businesses and would be repealed.
Individual taxation. The framework replaces the current seven-bracket system with three rates of 12, 25 and 35 percent. The framework contemplates a higher top rate on the highest income taxpayers to keep the rate structure as progressive as the existing code, but leaves it to the tax-writing committees to make that determination. While the framework specifies the above rates, it does not specify at what taxable income level they would apply. Presumably, the tax committees will address adjusting the income thresholds as part of the budget process.
Existing Affordable Care Act taxes, including the 3.8 percent net investment income tax and the 0.9 percent additional Medicare tax, are not specifically repealed in the framework. It is unclear whether the tax-writing committees will retain these taxes at the current thresholds.
To offset the rate reductions, most itemized deductions would be discontinued except for the mortgage interest and charitable contribution deductions. The biggest impact here is the elimination of the deduction for state income and real estate taxes, which would significantly affect residents of the highest-taxed states. The individual AMT would also be repealed.
If the deduction for state and local taxes is eliminated, this proposal would, in substance, replace the current regular tax system with the AMT, since a leading reason individuals are subject to the AMT is large tax deductions. Also, the standard deduction would be doubled and the child tax credit for families would be increased in exchange for the repeal of personal exemptions for individuals and dependents.
Retirement account changes. The framework retains tax benefits for retirement accounts but urges the tax committees to simplify the rules for these benefits. It has been speculated that changes would be made to eliminate pre-tax contributions to 401(k) and other retirement plans and basically replace pre-tax plans with Roth accounts. The framework does not address this, but as Congress looks for revenue-raisers to offset rate reductions, look for changes of these rules to be considered.
Estate tax eliminated. The framework eliminates the estate tax which applies to estates worth at least $5.49 million per tax filer. Please note that the gift tax remains in effect.
Basic reform of the code. The framework does not address complexities in either the code or regulations that increase the cost of taxpayer compliance. It remains unclear if either tax-writing committee will look at greater simplification as opposed to this framework which more closely resembles a tax cut versus comprehensive reform.
Summary. The rate reductions are expected to add $1.5 trillion to the deficit over the next 10 years. Without offsetting spending reductions or budget rule revisions, these rate reductions will be required to sunset after 10 years, similar to the Bush tax cuts enacted in 2001.
An early analysis of the plan by the nonpartisan Tax Foundation think tank estimates federal revenues would be reduced by roughly $5 trillion over a decade, without factoring in spending offsets. Architects of the plan say the tax cuts would be offset by new revenues raised from removing tax expenditures. The framework preliminarily identifies the elimination of all itemized deductions apart from those for charitable contributions and mortgage interest, the IRC 199 manufacturing deduction and the deduction of interest by corporations as means to accomplish this objective.
The cost of enacting significant rate reductions plus the elimination of tax deductions (impacting high-tax states) could make this package difficult to pass in its current form. As we have seen with the multiple attempts to repeal the Affordable Care Act, one party controlling both houses of Congress and the White House creates no certainty of passage.
Time may also work against completing any tax reform package before the end of the year. After Oct. 1, only 35 working days remain on the House calendar before representatives adjourn for the holidays. Consequently, we expect debate to extend into early 2018 and anticipate there will be a need for some compromises to bring enough Democrats on board if reform is to be enacted.
In addition, it is difficult to predict whether other political distractions will affect Congress’s agenda. If tax reform is deferred too far into 2018, it may prove unpassable as we near midterm elections. If further delayed into 2019, the window for passage may be even shorter due to the ever-expanding presidential election period.
As a result, we believe you should continue to focus your 2017 tax planning as if nothing will be enacted this year. Consequently, the time-honored tax advice of “defer, defer, defer” continues to apply:
- Defer income. For example, cash-basis taxpayers may consider not billing clients until January if cash flow needs permit.
- Maximize contributions to 401(k)s and other pre-tax retirement accounts in 2017. If this means saving less in 2018 so the net savings between the two years is the same, the tax savings may be worth it.
- Postpone retirement account withdrawals. If you are retired and withdrawing money from a retirement plan, cash flow permitting, consider suspending any additional withdraws for 2017 and catching up in 2018.
- Accelerate state tax payments. If you have flexibility in when you can pay your real estate taxes, accelerate the payment — as well as 2017 state income tax payments — into 2017.
Caution: Accelerating certain deductions into 2017 could trigger the AMT, defeating the purpose of claiming the additional deductions in the first place. We recommend you meet with your tax advisor to run multiyear projections to determine the best strategy for your personal situation.
For related insights and in-depth analysis, see our tax reform resource center.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.