Lower and Fewer Tax Rates; Goodbye (Part of) Obamacare

Lower and Fewer Tax Rates; Goodbye (Part of) Obamacare

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On Wednesday, April 27, President Trump unveiled a basic overview of his proposed tax plan, with Treasury Secretary Steven Mnuchin and National Economic Council director Gary Cohn sharing the news with the press.

Under current law, we pay tax on “ordinary income” — things like wages and interest income — at graduated rates, meaning as income increases, so does the tax rate. There are currently seven rates, stretching from 10% to 39.6%.

Of course, the top rate isn’t really 39.6%, because as part of Obamacare, high-income taxpayers pay an additional 3.8% surtax on “net investment income” — things like interest, rents, royalties, and passive business income — bringing the real top rate to 43.4%.

We don’t pay these rates on all forms of income, however. Certain types of income — namely, qualified dividends and long-term capital gains (the sale of certain assets held longer than one year) — are taxed at preferential rates, which under current law are 15% for most taxpayers, but reach a maximum of 20% for taxpayers in the 39.6% bracket, before tacking on an additional 3.8% for the Obamacare net investment income tax.

President Trump has proposed cutting the seven brackets down to three: with 10%, 25%, with 35% rates. The rate on capital gains and dividends would top out at 20%, and he would then eliminate the net investment income tax, making the “true” top rates on ordinary income and capital gains 35% and 20%, respectively.

No More Estate Tax or Alternative Minimum Tax

Under current law, if you die with an estate valued in excess of $5.45 million, you pay a tax of 40% on the excess value. Any appreciation inherent in the assets that make up your estate, however, is untaxed at your death; rather, the beneficiaries of your estate take the assets with a tax-free, “stepped-up” basis. President Trump’s proposal would eliminate the estate tax.

The Alternative Minimum Tax — a required parallel tax computation that ensures individuals pay a minimum effective tax and that has long outlived its usefulness — would also be eliminated.

Huge Business Tax Cuts

Corporations currently pay tax at a rate of 35%, which President Trump likes to point out is the highest rate in the industrialized world. His proposal would cut the rate to 15%.

Under current law, S corporations and partnerships do not pay entity-level tax; instead, the income is allocated to the owners, who pay the corresponding tax at the individual level, based on the applicable individual rates laid out above.

Trump, however, would provide a unified business rate of 15%, meaning not only would corporations pay tax at that rate, but all business income — even the income earned by an individual from an S corporation or partnership and reported on the individual’s tax return — will be subject to the same 15% rate. This means that a taxpayer earning business income would experience a drop in top tax rate from 39.6% to 15% under the Trump presidency.

It also means that under the Trump plan, the difference in top tax rate between paid as an employee (35%) and as an independent contractor (15%) is extremely significant.

Certain Low-Income Taxpayers Take a Hit

Every taxpayer gets to claim on their tax return the greater of 1. certain “itemized deductions,” — think charitable contributions, mortgage interest, real estate taxes, etc… or 2. a “standard deduction.” The standard deduction currently sits at $12,600 (if married, half that if single). In addition, each taxpayer may claim a $4,050 personal exemption for themselves, their spouse, and any dependents.

President Trump’s proposal would eliminate all itemized deductions other than mortgage interest and charitable contributions. This is a deviation from the proposal published during his campaign, which would have capped itemized deductions at $200,000 (if married, $100,000 if single).

In addition, the plan would increase the standard deduction from $12,600 to $24,000 ($12,000 if single), and eliminate personal exemptions.

So if you’re scoring at home, a family of five that currently claims the standard deduction will actually lose deductions under the Trump plan. Under current law, they would be entitled to a $12,600 standard deduction and $20,250 of personal exemptions, for a total tax benefit of $32,850. Under this latest proposal, that would be replaced with a $24,000 standard deduction and no personal exemptions. That’s going to be a tough sell.

Trump Pivots on International Taxation

For the better part of the past few months, the discussion of tax reform has centered around an idea floated by Speaker of the House Paul Ryan and Chairman of the House Ways and Means Committee Kevin Brady known as the “border adjustment tax.” The tax, which you can read about here if you have an overwhelming desire to learn about things that no longer matter, would have changed the way the U.S. taxes imports and exports. The corporate rate would have dropped to 20% — rather than 15% — and would only be applied to goods consumed in the U.S.; exported sales would have been exempt.

So in effect, a tax of 20% would have been imposed on imports, but not exports. Because the U.S. operates at a $500 billion trade deficit each year, the tax was expected to raise over $1 trillion in tax revenue over the next decade, which Ryan and Brady planned to use to pay for, in part, the reduced corporate tax rate.

President Trump never formally endorsed the border adjustment tax, and yesterday appeared to represent its demise, as the President instead proposed a move to a territorial tax system, where a U.S. corporation that generates revenue through a foreign affiliate in a foreign country will never pay U.S. tax on those foreign earnings.

This is a departure from our current system, which is a “deferral system,” and works like so: if a U.S. corporation sets up a subsidiary in, say, China, any revenue earned in China is not subject to U.S. tax until the Chinese subsidiary distributes the cash back to the U.S. parent corporation. As you might guess, this deferral system presents tremendous motivation for U.S. corporations earning money overseas to leave the cash abroad; as a result, there is reputed to be over $2.5 trillion in profits attributable to U.S. companies stuck in overseas markets.

The President would seek to bring some of that cash home by assessing a one-time tax — though the rate wasn’t clarified yesterday – that would likely be payable over a number of years.

Anthony Nitti, CPA, Partner Anthony Nitti, CPA, Partner
970-925-7382
[email protected]
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