Tax reform framework: Our analysis
On September 27, 2017, the Big Six working group released a framework for proceeding with tax reform legislation (the “Unified Framework for Fixing Our Broken Tax Code”). The individuals included in the Big Six are:
- Steven Mnuchin, Treasury Secretary
- Gary Cohn, Director, National Economic Council
- Paul Ryan, Speaker of the House
- Kevin Brady, Chair, House Ways and Means Committee
- Mitch McConnell, Senate Majority Leader
- Orin Hatch, Chair, Senate Finance Committee
The framework outlines four guiding principles for tax reform:
- Make the Tax Code simpler, fairer, and easier to understand.
- Reduce the tax burden on American workers.
- Make the United States more attractive to businesses by reducing the tax burden in line with other countries.
- Repatriate offshore earnings to spur reinvestment in the United States economy.
While the framework identifies a number of guidelines for tax reform, it doesn’t provide exhaustive detail. Instead, its stated objective is to serve “as a template for the tax-writing committees of the House and Senate that will develop legislation through a transparent and inclusive committee process.” To that end, the Chairmen issuing the framework “welcome and encourage bipartisan support and participation."
A number of the guidelines included in the framework could generate broad, bipartisan support. However, other provisions will likely engender a significant amount of political rancor. Accordingly, the lack of specificity regarding key provisions may allow for political negotiations that could result in a more bipartisan legislative approach to tax reform than other recent legislative efforts.
The framework makes consistent reference to middle-income earners when describing the provisions related to individual taxes. However, the undefined details make it difficult to fully examine the impact of such provisions on middle-income taxpayers. In any case, the following areas have been identified for reform by the framework:
- Standard deduction
The standard deductions and personal exemptions would be consolidated into a single, standard deduction of:
- $24,000 for married taxpayers filing jointly, and
- $12,000 for single taxpayers
The framework describes this as a “doubling” of the standard deduction and the creation of a “zero tax bracket” for the first $24,000 of income earned by a married couple and the first $12,000 of income earned by an individual. However, the elimination of the personal exemption suggests a more modest benefit. As compared to 2017, this would increase the standard deduction by $1,600 for single individuals ($12,000, less $10,400 (or $6,350 plus $4,050) and $3,200 for married taxpayers filing jointly ($24,000, less $20,800 (or $12,700 plus $8,100). If a taxpayer has even one dependent for whom they’re also losing the personal exemption, this provision may end up being unfavorable to them.
- Individual tax rates
The framework would consolidate the current seven tax brackets (10, 15, 25, 28, 33, 35, and 39.6 percent) into three brackets of 12, 25, and 35 percent. It's currently unclear what taxable income thresholds would apply to those brackets. The framework also indicates a willingness to add an additional tax bracket in excess of 35 percent to ensure that the tax burden won't be shifted from the highest income earners to lower- and middle-income taxpayers. These tax bracket guidelines are in line with expectations for tax reform, but specific analysis will be difficult in the absence of direction regarding the applicable income thresholds.
- Itemized deductions
The framework proposes the elimination of “most” itemized deductions, except for the home mortgage interest deduction and charitable contribution deduction. While it's not clear exactly which itemized deductions are intended to be included in “most,” it's anticipated that the deduction for state and local taxes would be eliminated given the amount of revenue that will be necessary to offset the decrease in tax rates. If this occurs, it will likely lead to significant political pressure in high-tax jurisdictions, such as New York, New Jersey, Illinois, and California.
While the framework identifies a number of guidelines for tax reform, it doesn’t provide exhaustive detail.
- Alternative minimum tax
In accordance with the simplification principle, the framework proposes the elimination of the individual alternative minimum tax (AMT). Repeal of the AMT is likely to be beneficial for taxpayers in high-tax jurisdictions, assuming the itemized deduction for state and local taxes survives reform. Additional detail regarding the income subject to the new consolidated tax brackets will be necessary to fully analyze the likely impact of both the itemized deduction reform and repeal of AMT.
- Estate tax and generation-skipping transfer tax
The framework proposes outright repeal of the estate tax as well as the generation-skipping transfer (GST) tax. Consistent with recent efforts in this area, repeal of the estate and GST taxes will likely meet significant resistance in Congress and could impact the potential for bipartisan support given that this tax generally only applies to taxpayers with estates in excess of $5 million. Note that the gift tax is not discussed within the framework, so it would appear that it would remain in place. This is presumably intentional in order to prevent income shifting from taxpayers in higher tax brackets to taxpayers in lower tax brackets.
- Child tax credit and work, education, and retirement
The Child Tax Credit is expected to be “significantly” increased, with the first $1,000 continuing to be refundable. The framework indicates that the phase out for this credit will be increased so that it will be more widely available to middle-income families. The framework further provides for the maintenance and improved efficiency of tax benefits encouraging work, higher education, and retirement plans.
The framework outlines a number of provisions that are intended to make American businesses, including small businesses, more competitive.
- Corporate tax rate
For corporations, the tax rate would be reduced to 20 percent, and the corporate AMT would be eliminated. The framework indicates that this would be below the average 22.5 percent tax rate among industrialized nations. It further recommends that the House Ways & Means Committee and Senate Finance Committee consider methods to reduce double-taxation of corporate earnings. It's not clear whether the 15 percent corporate tax bracket would be maintained.
- Tax rate for pass-through business income
There has been significant discussion over the past few years regarding the creation of a tax rate structure applicable to business income from partnerships, S corporations, and sole proprietorships in order to provide parity between the tax applied to income of corporations and pass-through businesses if the corporate tax rate is decreased. The framework proposes a 25 percent rate that will be applicable to business income from pass-through entities. However, the committees are left with the difficult task of drafting measures to prevent the conversion of “personal income” into business income that is subject to this preferential rate.
Businesses in general will benefit from lower tax rates.
- Expensing capital expenditures and deducting interest expense
The framework describes a system of “unprecedented expensing” of eligible capital expenditures over a period of at least five years and applies to all depreciable assets other than structures. The immediate expensing of depreciable assets will provide a significant benefit to capital intensive businesses, such as manufacturers.
- Interest expense limitation
The framework indicates that net interest expense will be “partially limited” for corporations and that Congress will “consider the appropriate treatment of interest paid by non-corporate taxpayers.” This limitation will be problematic for certain types of highly-leveraged businesses, such as real estate developers, private equity funds, financial institutions, and utilities.
- Deductions and credits
The framework indicates that the domestic production activities deduction (DPAD) will no longer be necessary to favor domestic manufacturers due to the proposed reduction in marginal tax rates. Conversely, two tax credits — research and development and low-income housing — would be specifically preserved. All other business credits and deductions are proposed to be eliminated unless “budgetary limitations allow” them to be preserved.
The framework would make significant changes to the taxation of American companies that operate abroad.
- Repatriation of accumulated earnings
Foreign earnings of U.S. companies that have been accumulated overseas would be deemed to be immediately repatriated. This would likely result in the immediate recognition of income in the United States. To alleviate the immediate adverse impact of that change, the framework proposes two softening measures. First, a higher tax rate would be applied to earnings held in cash and cash equivalents, while a lower rate would be applied to earnings held in illiquid assets. Second, payment of the tax liability may be spread over “a period of years.”
- Taxation of foreign profits
The framework intends to exclude 100 percent of the dividends from foreign subsidiaries if the U.S. parent owns at least 10 percent of the subsidiary. However, “in order to prevent companies from shifting profits to tax havens,” the framework also proposes to tax the foreign profits of U.S. multinational corporations at a reduced rate. The difficult task of creating rules to establish a line between legitimate foreign earnings exempted from U.S. tax and foreign earnings that have been inappropriately shifted and should be subject to U.S. tax has been left to the congressional committees.
The impact on individual taxpayers, other than with respect to the tax rate applicable to their pass-through business income, will be mixed.
Winners and losers
While it's too early to make final judgments, the framework seems to have a few clear winners, a few clear losers, and a lot of unanswered questions pending the results of the congressional committee drafting efforts.
- Businesses in general will benefit from lower tax rates. The maximum C corporation rate will drop from 35 percent to 20 percent, while individual owners of pass-through businesses, like S corporations and partnerships, would see the maximum tax rate on the income from their business operations drop from 39.6 percent to 25 percent.
- Capital-intensive businesses, including many manufacturers for example, will benefit from expensing new investment in plant and equipment as well as from lower tax rates on their business income.
- The benefit to real estate businesses is less clear since the loss of interest deductions and loss of the benefit of immediate expensing would offset some of the reduced tax rate benefit.
“In order to prevent companies from shifting profits to tax havens,” the framework proposes to tax foreign profits of U.S. multinational corporations at a reduced rate.
- The impact on individual taxpayers, other than with respect to the tax rate applicable to their pass-through business income, will be mixed.
- The lowest income taxpayers will see the tax burden reduced or eliminated by the increased standard deduction.
- An increased standard deduction and fewer itemized deductions would simplify the tax preparation process for many taxpayers but may result in increased taxes for some middle-income taxpayers.
- Taxpayers in states with high tax rates, who weren’t previously caught in the AMT, would lose a significant benefit if the elimination of the deduction for state and local taxes survives the legislative drafting process.
- Internationally active businesses with accumulated earnings held outside the United States will be hit with a significant, up-front repatriation tax that will offset the benefit of the reduced business tax rates. But future foreign earnings may be completely free of U.S. tax, leading to increased cash flow and a much more fluid movement of cash around the world.
If you have any questions about how the framework may affect you or your business, please let us know.