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Unified Framework for Tax Reform – A “Small Step” or a “Giant Leap”?

September 28, 2017

Trump administration officials and Republican congressional leaders (collectively known as the Big Six) have released their “framework” for tax reform, the Unified Framework for Fixing Our Broken Tax Code. The framework is a high-level document, designed to provide guidance to Congressional tax-writing committees—House Ways and Means and Senate Finance—but leaving them with the most difficult job of working out the details. A copy of the official release document can be found here.

During a speech in Indiana, President Trump stressed the key goals of tax reform to be:

  1. Reducing taxes for “ordinary hard working Americans”
  2. Making the tax code more “fair” and “simple” so that most people will be able to file their federal tax returns with the IRS “on a single sheet of paper”
  3. Cutting taxes on American businesses in order to restore jobs and be more globally competitive
  4. Encouraging corporations to repatriate earnings held overseas

The biggest item missing from the framework discussion points is how, or if, the reform proposals will be paid for.

Highlights of the framework’s tax reform proposals include:

Individual Tax Reform

  • Consolidate the current seven tax brackets into three brackets of 12 percent, 25 percent and 35 percent. The framework hints that a fourth, higher, tax bracket may be needed “to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the burden from high-income to lower- and middle-income taxpayers.” The framework does not mention income levels for the tax rate brackets.
  • Double, almost, the standard deduction in order to simplify tax filings and provide additional relief to lower/middle-income taxpayers. The framework calls for a $12,000 standard deduction for single filers, or $24,000 for married couples. This standard deduction replaces not only the current standard deduction, but also personal exemptions. Consequently, larger families and elderly taxpayers may find this proposal reduces their overall deductions, while smaller households may benefit.
  • Eliminate “most” itemized deductions but retaining those for home mortgage interest and charitable donations. The proposed elimination of deductions for state and local taxes will be a hotly debated issue especially among senators and representatives from high tax states. The framework also recommends retaining tax benefits that encourage work, higher education and retirement savings and, if possible, simplifying them.  
  • Increase the income levels at which the child tax credit phases out, with no apparent change to the $1,000 per child credit amount.  The framework also recommends a new tax credit of $500 for costs of caring for non-child dependents (such as elderly parents).
  • Repeal both the alternative minimum tax (AMT) and the estate tax.  The framework also calls for repeal of the generation-skipping tax, but not the gift tax.
  • Net Investment Income Tax and capital gain rates not mentioned in the framework.  The lack of comment in the framework may imply they remain in place.
  • Tax incentives for retirement, such as IRA and 401(k) plans, appear to remain in place. The framework says a goal should be “to maintain or raise retirement plan participation of workers and the resources available for retirement.” But, this area could still be subject to change.

Business Tax Reform

  • Reduce the top corporate tax rate to 20 percent. The framework also “aims” to eliminate the corporate AMT. It also opens the door for the tax-writing committees to explore a partial corporate level deduction for dividends paid—often referred to as “corporate integration.” 
  • Provide a top tax rate of 25 percent on “business income” generated by sole-proprietorships and pass-through entities (partnerships, S corporations and LLCs).  Congressional tax writing committees will need to develop a definition of what constitutes “business income” so that it can be distinguished from reasonable compensation for services (which would be taxed at the individual tax rates).
  • A one-time tax, payable over “several years,” on the deemed repatriation of corporate foreign earnings held or invested overseas. The framework suggests a lower tax rate on foreign earnings that have been invested in illiquid assets and a higher rate for foreign earnings held in “cash or cash equivalents.” However, it does not target particular rates. 
  • Move to a “territorial” tax system that provides a 100 percent deduction for dividends received by corporations from their foreign subsidiaries (at least 10 percent owned).
  • No Border Adjustment Tax (BAT) on imports. The revenue raising BAT proposal was heavily criticized by businesses that import goods and products and is, as expected, missing from the framework.
  • Full expensing of new investments in depreciable assets other than structures for at least five years, effective for purchases made after September 27, 2017.  The framework appears to drop real property from the expensing proposal. The given effective date, which will most likely be earlier than the effective date of the framework tax reforms, could produce some interesting tax planning issues for 2017 if the tax reform legislation is not effective until 2018.
  • Partial limitation on deductibility of business net interest expense for regular corporations.  The framework document does not say to what extent interest expense deductions may be limited. The framework also suggests the Con­gressional tax writing committees consider “the appropriate treatment of interest paid by non-corporate taxpayers.”
  • The research and development and low-income house tax credits are retained, but the existing domestic production (section 199) deduction is eliminated. Other business tax credits would likely be repealed, but some could be spared depending on budget limitations. 
  • “Modernize” the rules governing the tax treatment of certain industries. Presumably, this may result in separate tax provisions for some specialized industries. Possible targets include: financial institutions, insurance companies, hedge funds and professional service firms, which have been mentioned as deserving “special rules” to reduce the potential for tax avoidance. This could also impact large cash-basis farmers.
  • Incorporate rules to “level the playing field” between U.S.-headquartered parent companies and foreign-headquartered parent companies.

Prospects­
Expect potentially contentious debate during hearings to be held in the next couple of months as Congress wrestles with procedural issues, projected budget deficits and economic growth projections. Still, an important hurdle has been cleared with the unveiling of the framework. A group of conservative and libertarian lawmakers, the House Freedom Caucus, has agreed to support the framework and the budget resolution process planned be used to pass the tax reform legislation. However, there remain many political challenges and hurdles to enacting tax reform legislation this year, or next.

Planning
Potential tax planning opportunities provided by framework tax reform changes will depend on transition rules and the effective dates of the various changes. Some provisions, like the full expensing of equipment purchases, may be effective in 2017 while others may be effective in 2018. Taxpayers not facing alternative minimum tax in 2017 and itemizing deductions should at least prepare to pay their fourth quarter state tax estimate and their balance due before year-end. 

Assuming the basic tax rate changes will not be effective until 2018, the potentially higher tax rates in 2017 will provide an incentive to defer income to 2018, or later years, and accelerate deductions that can effectively be utilized under current tax law into 2017, particularly those being eliminated—subject, of course, to limitations and to the AMT. Detailed analyses will need to be completed to determine the advisability of taking action on any proposed tax planning steps.

Should you have questions concerning the tax reform proposals or want to explore specific tax planning alternatives, contact your Eide Bailly, LLP professional.