On September 27, 2017, the Trump Administration, the House Committee on Ways and Means and the Senate Committee on Finance released their much-anticipated framework for tax reform (the “Framework”). The Framework generally proposes to lower taxes on most businesses and individuals and to simplify the US federal income tax system. The Framework sets forth broad principles for tax reform and leaves numerous important details and decisions to the tax-writing Congressional committees.
Summary of Framework
On April 26, 2017, the Trump Administration released a paper setting forth several “core principles” of its tax plan. Since then, the “Big Six” tax reform negotiators - House Ways and Means Committee Chair Kevin Brady; House Speaker Paul Ryan; Senate Majority Leader Mitch McConnell; Senate Finance Committee Chair Orrin Hatch; Treasury Secretary Steven Mnuchin; and National Economic Council Director Gary Cohn – have been working to develop an overall framework for tax reform.
While the Framework lacks significant details and leaves open many specifics, the Framework’s broad contours of a tax reform plan are summarized below.
The Framework would reduce the number of tax brackets for individuals from seven to three, with rates of 12 percent, 25 percent, and 35 percent. The Framework provides that a fourth top rate may apply to the highest-income taxpayers. The Framework does not state at what income levels the three different brackets or the potential fourth bracket would apply. The fourth bracket may be used to help reduce the cost of the overall tax changes.
The Framework proposes to roughly double the standard deduction to $12,000 for single filers and $24,000 for married taxpayers filing jointly. The Framework would repeal personal exemptions for dependents and increase the child tax credit by an unspecified amount, while increasing the income levels at which the credit begins to phase out. Furthermore, the Framework would provide a non-refundable credit of $500 for non-child dependents.
It is expected that the increase in the standard deduction would significantly decrease the number of taxpayers that would itemize their deductions (which perhaps would be a step towards a “postcard tax return”).
The plan would eliminate most itemized deductions other than the home mortgage interest expense and charitable contribution deductions. While the Framework does not specifically mention elimination of the state and local tax deduction, the Framework appears to propose such elimination, which is consistent with the Trump Administration’s focus on elimination of this deduction. Democrats are likely to oppose the elimination of this deduction and, as there are 52 House of Representative Republicans in states that disproportionately use the state and local tax deduction, it is unclear whether the elimination of the deduction will garner enough support to be included in a final tax bill.
The Framework also would eliminate the alternative minimum tax and the estate tax, which applies to estates currently worth more than $5.49 million for individuals and $10.98 million for couples. The Framework does not mention the elimination of the gift tax that is currently imposed on gifts over $14,000, subject to the unified lifetime exemption for estate and gift taxes.
Notably, the Framework does not propose elimination of the 3.8 percent net investment income tax that applies to individual taxpayers earning more than $200,000 a year or married taxpayers filing jointly earning more than $250,000 a year, which was enacted as part of the Affordable Care Act. The Framework does not propose any modification of the reduced tax rate on long-term capital gains and other types of investment income.
The Framework provides for a reduction in the corporate tax rate from 35 percent to 20 percent. Furthermore, the Framework would eliminate the corporate alternative minimum tax. Finally, the Framework states that Congressional committees may consider methods to reduce the double taxation of corporate earnings, but does not specifically include a dividends paid deduction or other corporate integration proposal.
Reduced Rate on Pass-Through Income
The Framework would limit the maximum tax rate applicable to the taxable income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25 percent. Under current law, partners or shareholders in flow-through entities are generally taxed on the income received at applicable individual income tax rates. The Framework does not define the scope of the small and family-owned businesses that would benefit from the lower rate but suggests that the tax reform bill will include provisions to prevent wealthy individuals from characterizing wages and other personal income as pass-through business income. The manner in which such provisions operate to prevent attempts at recharacterizing compensation and other similar income as business income would be critically important to the tax treatment of non-corporate businesses and how they may benefit from such lower rate. The Framework does not include a proposal regarding carried interest reform.
Other Business Provisions
The Framework would also permit businesses to immediately expense the cost of new investments in depreciable assets other than structures made after September 27, 2017, for at least five years. It is unclear whether businesses that acquire amortizable intangible assets (generally amortizable over a 15-year period under a straight line method), such as certain types of intellectual property or goodwill, would be entitled to immediately expense the cost of such investments.
Under the Framework proposal, net interest expense incurred by C corporations would be partially limited. The Framework, however, provides no details on how interest deductions would be limited. The Framework states that the committees will also consider the appropriate treatment of interest paid by non-corporate taxpayers.
The Framework would eliminate the current-law domestic production deduction under section 199 of the Code and other types of special exclusions and deductions, but would preserve the research and development credit and the low-income housing credit. The Framework does not provide details, but this proposal could eliminate, among other credits, energy-related credits.
The Framework states that special tax regimes would be modernized to ensure the Code “better reflects economic reality and that such tax rules provide little opportunity for tax avoidance.” In this regard, the Framework does not explain what special tax regimes would be modified or eliminated. The Framework leaves unclear whether a mark-to-market regime on derivatives is contemplated.
International Tax Reform
The Framework states that it would move the US international tax regime to a territorial system. The current worldwide tax system generally taxes foreign profits when they are repatriated to the United States, subject to a foreign tax credit. The current system also effectively permits indefinite deferral of most foreign operating profits until such profits are repatriated to the United States.
The Framework’s “territorial” system would apply a 100 percent exemption from US tax for dividends from foreign subsidiaries in which the US shareholder owns at least a 10 percent stake. It is unclear whether the 100 percent exemption would be limited to dividends to US shareholders from “controlled foreign corporations” or whether it would apply to any 10-percent owned foreign corporations. The Framework does not mention an exemption for foreign income of US shareholders that is not earned through foreign corporate subsidiaries. Also, the Framework does not address how dispositions of foreign businesses would be handled under the “territorial” system.
Notwithstanding the Framework’s description of its proposals as “territorial taxation,” it also states that to prevent companies from shifting profits to tax havens, rules would be included to protect the US tax base by taxing foreign profits of US multinationals at a reduced rate. The scope of this proposal is not explained in the Framework.
There are significant details regarding the move to a so-called territorial system and the imposition of a reduced tax rate on global profits that would need to be finalized in the legislative text. It is unclear how any legislative proposal would handle the treatment of hot-button items such as the treatment of intangibles, sales of foreign manufactured goods into the US and the taxation of foreign royalties.
As a transition measure, the Framework would impose a one-time tax on existing foreign profits held offshore, which have been accumulated under the current worldwide tax system and have been estimated to be as much as $2.6 trillion. The Framework would apply the one-time tax to accumulated foreign earnings held in illiquid assets at a lower tax rate than accumulated foreign earnings held in cash or cash equivalents. The one-time tax would be payable over several years.
Finally, the Framework also states that the tax-writing committees will include in a tax reform bill “rules to level the playing field between US-headquartered parent companies and foreign-headquartered parent companies.” The specifics of this proposal are also not explained in the Framework.
The Framework leaves many questions unanswered and provides little detail on significant proposals. Given the slim Republican majority in the Senate, any bill may require passage by simple majority through the reconciliation process. Reconciliation allows the bill to pass with only 50 votes (with Vice President Pence casting a tie-breaking vote), rather than 60 votes, but is only permitted for bills that do not add to the deficit beyond a ten-year window after passage. Accordingly, the tax rate reductions, if enacted, may be temporary unless accompanied by substantial revenue offsets.
Members of the Big Six have recently suggested that they intend to push for tax reform by the end of 2017. Given the differences between the Trump Administration and Congress, the expectation of significant opposition to any comprehensive tax reform proposals and the complexity of comprehensive proposals, the enactment of a comprehensive tax reform bill into law by the end of 2017 will likely face significant hurdles and even if tax reform is ultimately passed the process could take a significant period of time.
The Framework does not state to what periods it would apply, other than the expensing of capital investments that would apply to the cost of investments after September 27, 2017. As with many significant changes in law, the effective date of such changes is expected to be prospective, although it is possible that the effective date could be retroactive in some respects.