An Exciting Tax Year Appears Imminent: Proposals suggest major legislative action, but much remains unclear

Wednesday, December 7, 2016 - 14:16
Gerald V. Thomas II

Gerald V. Thomas II

Introduction: President-elect Donald Trump has indicated that one of his priorities is comprehensive tax reform and lower individual and business tax rates. Leaders of the Republican-controlled Congress have expressed similar views. Accordingly, comprehensive tax reform in 2017 is a real possibility. Gerald V. Thomas II with McGuireWoods is experienced in tax planning and navigating the U.S. tax code for his clients. Below, he discusses potential tax legislation in 2017 and the impact it could have on businesses. His remarks have been edited for length and style.

MCC: Why does President-elect Trump want Congress to enact sweeping changes to the Internal Revenue Code?

Thomas: President-elect Trump has said that he wants to reduce taxes for individuals and businesses across the board to make U.S. companies more competitive globally, to retain jobs in the U.S. and to increase economic growth in the U.S.

MCC: Is President-elect Trump’s proposed tax plan similar to any prior positions of members of Congress?

Thomas: The tax plan on President-elect Trump’s website is very similar to the House Republicans’ tax reform blueprint titled “A Better Way: Our Vision for a Confident America,” which was released in June 2016. Accordingly, President-elect Trump should receive strong support from the Republican-controlled Congress to enact comprehensive tax reform although the ultimate Congressional proposals may be more in line with the House blueprint.

MCC: With a Republican-controlled Congress, is it an absolute certainty that the Republicans can push their and President-elect Trump’s agenda and enact comprehensive tax reform?

Thomas: The Republicans will have a majority in the House with 239 seats. However, they will have the slimmest majority in the Senate with 51 seats, with one race, Louisiana, to be decided in a December 10 statewide general election. The Republicans in the Senate can overcome Democratic opposition and approve legislation through a budget reconciliation process that needs only 51 votes to pass, as opposed to the 60 votes, or three-fifths majority, generally needed to avoid a filibuster and pass legislation. Yet, such a measure is not permanent and generally can’t extend beyond the budget horizon – typically 10 years. Also, other Congressional rules restrict the use of the budget reconciliation process for legislation. Senate Republicans could, however, try to reach a deal with Senate Democrats who may view a compromise as beneficial to their re-election campaigns in the near future.

MCC: Are there any potential tax changes affecting individuals under President-elect Trump’s plan and the House blueprint that could have an indirect impact on businesses?

Thomas: It is important to understand the individual tax landscape in evaluating how potential tax changes to individual taxes could impact the structure and operation of businesses. Here are key points with differences noted between Trump’s tax proposal and the House blueprint. I’ll elaborate on some of these items later in the discussion.

The number of individual income tax brackets would be reduced from seven brackets to three brackets. The top individual income tax rate would be reduced from 39.6 percent to 33 percent.

The individual alternative minimum tax would be eliminated.

Under the House blueprint, individuals would be taxed at half the individual tax rate on net capital gains on the disposition of corporate stock and the receipt of dividends from corporations. (President-elect Trump’s tax plan would retain the existing capital gains structure.)

Carried interest would be taxed as ordinary income rather than capital gains. (The House blueprint is silent on this point.)

The 3.8 percent net investment income tax enacted as part of the Affordable Care Act would be repealed. Note: bullets removed throughout because they don’t work in interview format.

MCC: Please provide us with a brief outline of the primary potential business tax changes under President-elect Trump’s plan and the House blueprint.

Thomas: Here are key points, with differences noted between Trump’s proposed tax plan and the House blueprint. I’ll elaborate on some of these items later in the discussion.

The top corporate income tax rate would be reduced from 35 percent to 15 percent (20 percent in the House proposal).

Owners of pass-through entities (partnerships, LLCs taxed as partnerships and S corporations) would be taxed on their pass-through income at a 15 percent rate (25 percent per the House blueprint).

The corporate alternative minimum tax would be repealed.

Most business deductions (including deductions for interest expense but excluding deductions for research and development) would be eliminated.

Companies engaged in manufacturing in the United States would be allowed to expense capital investment. The House would extend this treatment to all businesses.

The annual cap on business tax credits for employer-provided day care would increase from $150,000 to $500,000. Also, companies could exclude from their income any payments they make toward their employees’ childcare expenses.

A one-time 10 percent tax would be imposed on the repatriation of untaxed foreign profits of U.S. companies. The House blueprint would lower the rate to 8.75 percent for assets held in cash and 3.75 percent otherwise. As we will discuss later, the House also proposes more comprehensive international tax reform.

MCC: These potential changes to the U.S. tax system appear to be pretty significant. How do you see these changes affecting businesses?

Thomas: These would be some pretty significant changes to the U.S. tax system. Here are ways such changes might affect businesses.

One of the key decisions facing a business is whether to structure its business as a corporation or pass-through entity (S corporation, partnership or LLC taxed as partnership). The tax treatment of the structure is just one of the factors that go into such a decision. Most small businesses select a pass-through entity so that there is one level of tax at the owner level on their share of income of the entity. With a corporation, there is the “double tax” problem – tax is imposed on income earned at the corporate level and again at the individual level upon the distribution of income to the shareholders. If Trump’s proposal to reduce the corporate-level tax to 15 percent is adopted and the tax rate on certain dividends remains at 20 percent, the sum of those rates (35 percent) would be only two percentage points higher than the highest proposed individual income tax rate of 33 percent under his plan. Moreover, if the House blueprint is adopted, individuals would be taxed at half the individual tax rate on net capital gains on the disposition of corporate stock and the receipt of dividends from corporations. The proposed corporate income tax rate (20 percent) is higher under the House’s proposal than the rate under the president-elect’s plan, but the House’s capital gain rate reductions would provide some relief to the double tax problem of corporations and could remove some of the barriers for businesses to select a corporation as their choice of entity. However, even with such reductions, there would be a benefit to selecting a pass-through vehicle because of lower tax rates and one level of tax if owners of pass-through entities are taxed on their pass-through income at a 15 percent rate under the Trump plan or at a 25 percent rate under the House blueprint. The pass-through structure may remain more tax-efficient than the corporate structure, but the gap between the two tax rates of the relative structures may decrease depending on which proposals are ultimately enacted.

Permitting companies to expense their capital investments would allow companies to reinvest income without paying tax on it, creating incentives to reinvest such profits. Also, this would provide relief to owners of pass-through entities who are taxed on their share of income earned by the pass-through entity even if those owners don’t receive distributions of income. By allowing a deduction for reinvestment of profits in capital investments, the owners of pass-through entities would not be taxed on that income.

The elimination of the interest expense deduction and the reduction of individual income and capital gains tax rates could allow companies to decrease their reliance on debt. Companies seeking capital may find that individuals and other capital sources, including private equity funds, may prefer to structure their unsecured investments as equity, especially if the target is a pass-through entity.

If the employer-provided day care annual business tax credit cap is raised from $150,000 to $500,000 and other changes are made as previously discussed, companies should re-evaluate their on-site childcare programs and policies for making payments toward employees’ childcare expenses.

MCC: The taxation of carried interest has been in the news over the last several years. You indicated that under Trump’s plan carried interest would be taxed as ordinary income. Could you elaborate?

Thomas: Before discussing this point, let me explain that a carried interest (also known as a profits interest) is an interest in a partnership or an LLC taxed as a partnership granted to an individual in exchange for services provided to the issuing entity. Structured properly, a carried interest is not taxed at grant and potentially allows for the recipient to be taxed at long-term capital gains rates, which are lower than individual marginal tax rates. Under Trump’s plan, carried interest would be taxed as ordinary income, which, at first blush, would cause individuals to be taxed at a higher rate on such interests than under current law. However, under the Trump plan, owners of pass-through entities could be taxed on their share of pass-through income at a rate as a low as 15 percent. Accordingly, there is some question as to whether carried interests would be taxed at the lower pass-through rate of 15 percent or the higher individual ordinary income tax rate of possibly 33 percent. All indicators point to the latter, but this would cause disparate treatment as compared with other types of partnership interests. In response to such a change in the taxation of carried interest, companies could provide financing to individuals so that they could purchase regular partnership interests in their companies. Alternatively, businesses could issue regular partnership interests to holders that would be taxable. However, the reduced pass-through tax rate on income (if enacted) over the holding period could outweigh the upfront tax cost. Experienced tax practitioners may still be able to structure around these potential issues. Suffice it to say, there are numerous issues that will need to be addressed in changing the taxation of carried interests.

MCC: What is the most significant potential tax reform to the U.S. international tax system?

Thomas: Under the President-elect’s plan, a one-time 10 percent tax would be imposed on the repatriation of untaxed foreign profits of U.S. multinational companies to encourage reinvestment in the United States. The House blueprint would lower the rate to 8.75 percent for assets held in cash and 3.75 percent otherwise. If such measures were enacted, they would provide relief to multinational companies that wish to transfer foreign profits to the United States. Also, the House proposes a more comprehensive reform of the U.S. international tax system. It would replace the current U.S. worldwide tax system with a territorial tax system. The United States is the only industrialized country that uses the worldwide tax system, which taxes U.S. companies on their income regardless of where it is earned, though there is there is potential for deferral until the earnings are repatriated. The House would adopt the territorial system (which is used by virtually all of the major U.S. trading partners) whereby American companies would be taxed in the jurisdiction where income is earned but would be exempt from U.S. taxation. Such legislation, if passed, would profoundly affect U.S. multinational companies, which now maintain profits abroad to fund non-U.S. operations and use complex tax structures to avoid U.S taxes. Adopting a territorial tax system would allow U.S. multinational companies to manage their business taxes on a global basis without using complex tax structures and to repatriate funds to the United States without concern for potential tax inefficiencies. A territorial tax system and a lower corporate tax rate could persuade American companies that moved their headquarters overseas to avoid U.S. taxation to return to the United States. The potential for international tax reform should cause multinational companies considering international tax planning to put such measures on hold until Congress sorts out these issues in 2017 because there may be incentives for multinational companies to retain income in the United States instead of shifting it abroad.

MCC: If tax legislation is enacted in 2017 – especially new tax rates – do you expect it to be retroactive to January 1? If so, what does this mean for U.S. taxpayers?

Thomas: Our clients started asking us these questions the day after Mr. Trump was elected. We have no crystal ball to predict whether any 2017 legislation will be made retroactive to the beginning of the year. However, there is a real possibility it could happen. There is precedent for retroactive treatment of tax legislation. For example, the reductions to the individual income tax rates in the Economic Growth and Tax Relief Reconciliation Act of 2001, enacted June 7 of that year, were retroactive to taxable years beginning on or after January 1, 2001. In the Jobs and Growth Tax Relief Reconciliation Act of 2003, the capital gains tax rate reductions were effective for sales and exchanges after May 6, 2003, which is the date of the House Ways and Means markup, and before January 1, 2009. The bill was signed into law on May 28, 2003. The possibility of new tax legislation in 2017 being applied retroactively is not lost on taxpayers. We are already seeing many business transactions that were expected to close this year being postponed until the first business day of January 2017. Given that there are no signs of increased tax rates in 2017 and absent any special considerations of a particular taxpayer’s tax situation, there is no downside to a taxpayer waiting to trigger taxable income on or after January 1, 2017.

MCC: If there is a single piece of advice you could give to a company considering its operations in light of potential tax legislation in 2017, what would it be?

Thomas: To remain flexible with respect to its structure and operations and stay in close contact with its tax advisors. Based on recent statements from Republican leaders of Congress, we expect significant tax legislation in 2017. Yet, the magnitude of it may depend on whether the Democrats and Republicans can compromise on certain key aspects and the cost of the tax legislation. President-elect Trump’s views on taxes and the landscape in Congress continues to evolve, so this is a fluid situation. In fact, there could be new developments by the time this article is published. We, as a firm, along with our public policy tax experts, continue to closely monitor the situation in Congress so we can advise our clients accordingly. The year 2017 promises to be an exciting one for taxes. It is not every day that we can say that.