Federal Tax Reform: Unified Framework Released

The White House and Congress presented this week their unified framework for tax reform. Major themes of the framework include broadening the tax base, providing tax relief to businesses and individuals, simplifying the tax code, and revising the current international tax system.

The framework is intended to be a guide for the committees in congress to draft detailed legislative language. Over the upcoming weeks and months Congressional committees will begin drafting legislative language, filling in the details not included in the framework. This alert summarizes the high-lights of the framework.

Individual Tax Changes

The tax reform framework contains several significant changes which will impact individual taxpayers. Most notably, the existing seven tax brackets – with rates ranging from 10% up to 39.6% – will be cut down to three: 12%, 25%, and 35%, with the possibility of an additional top tax rate for the highest-income taxpayers. Itemized deductions are largely eliminated – with the exception of: mortgage interest and charitable contribution deductions. Finally, the tax reform framework includes a repeal of the current individual Alternative Minimum Tax system.

Other individual tax highlights include:

  • Increased standard deduction amounts – to $12,000 for single filers and $24,000 for joint filers
  • Repeal of the estate tax and generation-skipping transfer tax
  • Elimination of exemptions for dependents
  • Benefits that encourage work, higher education and retirement security
  • Increased eligibility for Child Tax Credit

Domestic Business Tax Changes

One of the focal points of the tax reform framework is to encourage economic growth through empowerment of business entities. The extent to which a business is impacted by the proposal will depend – in large part – upon its organizational form.

C Corporations will see meaningful changes through the reduction of the maximum corporate tax rate from 35% down to 20%. The framework also limits the extent to which interest expense will be allowable as a deduction in computing a C Corporation’s taxable income.

Business income of small and family owned businesses conducted as partnerships (presumably including Limited Liability Companies), S-Corporations, and sole proprietorships (also known as “pass-throughs”) will be limited to a maximum income tax rate of 25%. However, the framework also addresses measures to prevent wealthy individuals from re-characterizing salary income as pass-through business income in an effort to avoid the top personal tax rate.

All businesses will be eligible to expense the full cost of certain investments in depreciable assets under the proposed framework (current expensing is generally limited to 50% of cost under the current tax regime). Eligible businesses may also continue to avail themselves of benefits from the Research & Development credit and certain low-income housing credits – which will remain in place under the proposed framework. In contrast, businesses will no longer be able to claim a tax benefit for the Domestic Production Activities Deduction as the tax reform proposal contemplates its repeal.

Global Businesses

The tax reform framework proposes a 100% exemption for dividends received by domestic taxpayers from foreign subsidiaries in which the domestic taxpayer owns at least 10% of outstanding ownership interests. This stands in stark contrast to the current tax system – under which earnings of foreign subsidiaries generally remain untaxed until the point at which they are repatriated to their domestic owners. In order to effectuate this sweeping change, the proposal will treat all untaxed accumulated foreign earnings as having been repatriated to the U.S. parent(s) and, therefore, subject to income tax. The dramatic impact of a one-time tax event will be partially-mitigated by allowing taxpayers the opportunity to pay any taxes on the deemed repatriation over a period of several years.

In an attempt to encourage the export of domestic products and services to foreign countries and to minimize shifting profits to tax havens, the proposal also alludes to broad, conceptual reductions in the tax on foreign profits earned by domestic businesses.

What this means for you

The framework sets the table for the most sweeping single change to tax law since the last tax reform act in 1986. The framework should be viewed as the first offer in a negotiation, in which we will see many more offers and counter-offers. Until legislative language is drafted or other details are released, we must rely on the framework to inform our expectations.

Some of the areas that many taxpayers will be interested in that were not addressed or was light on details include:

  • Loss of itemized deductions, such as the state and local tax and medical expense deductions
  • Will the LIFO inventory method be preserved?
  • How is the interest deduction limited for C corporations, and will it be limited for other businesses?
  • How will the territorial tax system function?
  • Over how many years will the repatriation tax be spread?
  • How will taxable income from pass-through businesses eligible for the reduced 25% tax rate be differentiated from pass-through income subject to the potentially higher individual tax rates?
  • Will the net operating loss rules change?
  • What benefits will be put in place to encourage work, higher education, and retirement security?
  • What are the top tax rates for capital gains, dividends, and individuals?

While it can be unsettling to contemplate the loss of treasured tax benefits, the general consensus is that through broadening the tax base and lowering tax rates, taxpayers can expect a reduction in the amount of federal income tax they pay. To prepare for the passage of tax legislation, all taxpayers can model their tax situation, assessing the impact of lost preferences and varying tax rates.

Businesses should assess and refresh as necessary tax planning previously implemented, or revisit tax planning that was not implemented, such as R&D credits and cost segregation studies. Deductions and credits are more valuable when deducted against the current high tax rates compared to the proposed reduced tax rate. Businesses also shouldn’t overlook the opportunity realize an effective tax rate benefit by implementing tax accounting method changes.

The general expectation is that passage of a tax bill in 2017 is possible. However, the reality is that 2018 is more realistic considering the amount of effort, study and negotiation that must go into such a significant piece of legislation.