President Donald Trump is coming into office with a tax plan designed to shake up the status quo.
Although Trump’s plan will likely take months or longer to implement, there are opportunities for people to take some important tax planning steps over the next few weeks. Despite the fact that the President tax plan still has many unknowns and no guarantees, preparation for next year and beyond should start now.
Scott Harty, a partner in Alston & Bird’s Federal & International Tax Group, sat down with Inside Counsel recently to discuss President Trump’s proposed tax plan.
“The President’s tax reform proposals and the GOP plan (proposed in the summer of 2016) are similar in many respects,” he explained. “While the President’s plan has some distinctions, indications are that the House has been using the GOP tax reform proposal as the basis for tax reform. The key points of the proposal appear to be business tax proposals and individual tax proposals.”
In terms of business tax proposals, according to Harty, the House is committed to shifting to a destination-based cash flow (DBCF) tax system. Under the current system, the place of economic activity is what gives rise to taxation, whereas under a DBCF system the place of sale would govern taxation.
So, top corporate income tax rates may be reduced from 35 percent to about 20 percent. And, base-broadening measures would be adopted that would include eliminating certain deductions, such as the proposal to end the deduction for interest expense. Taxation of pass-through income from businesses, which is currently subject to tax at a maximum rate of close to 40 percent, would be reduced to 25 percent.
Additionally, there may be a repatriation of deferred foreign profits at a rate of about 10 percent. The House could possibly move also to a territorial-based tax system that would exclude from taxation dividends paid by foreign subsidiaries.
However, it may maintain a portion of the Subpart F rules, particularly those regarding the treatment of passive income. Finally, one of the more controversial provisions relates to the border adjustability tax, which would impose a 20 percent tax on imports and would exclude exports from the U.S. tax base.
For individual tax proposals, according to Harty, the rate brackets for individuals would be condensed from seven brackets to three, with the marginal rates being 12 percent, 25 percent and 33 percent. Investment income would be taxed as ordinary income, but there would be a 50 percent deduction resulting in effective rates of six percent, 12.5 percent and 16.5 percent for such income.
Both the alternative minimum tax and estate tax would be repealed. The tax base would be broadened by limiting or eliminating most deductions. And, the mortgage interest and charitable deductions would be preserved, but there may be additional limitations placed on these deductions.
“The main distinctions from a business tax perspective are that the House plan proposes a territorial tax system, whereas the President’s plan proposed to end deferral of offshore income,” said Harty. “This difference seems to have been resolved because the House is moving forward with its tax proposal as the basis for tax reform.”
The President’s proposal was more specific than the House plan regarding tax reform for individuals, according to Harty. The House will need to determine how much it will broaden the base to pay for the reductions in the rate brackets. “Members will need to confront important deductions such as state taxes, charitable donations and interest expense, as well as caps that may be necessary to limit these deductions in order to pay for the costs of tax reform,” he said.
Both the House and the President want to be bold in their tax reform proposals, but revenue neutrality is also important. These proposals could add significantly to the deficit if they are not offset by corresponding revenue-raisers.
According to Harty, each of the proposals represents a significant shift in the way the U.S. taxes business income. If these provisions are enacted, tax practitioners and taxpayers will need to adjust how they think about the taxation of business income. Shifting from a worldwide-based system to a territorial system that is in many respects a consumption tax system will be disruptive and require many changes to the tax code.
So, how should businesses factor possible tax reform into their current tax planning?
“Right now, two key components of the legislation that seem to be drawing the most attention are the elimination of the deductibility of interest expense and the border adjustment,” said Harty. “If your business is leveraged, then you should pay close attention to how Congress chooses to treat interest expense.”
Also, there are likely to be grandfather provisions for debt and special carve-outs for financial institutions and insurance companies, but this provision could have a broad impact. Secondly, importers are focused on the border adjustment tax. Some believe the border adjustment effectively subsidizes exports and taxes imports, which can be detrimental to importers.
He explained, “Economists, however, seem to think that prices or exchange rates will adjust to offset these potential imbalances, although the adjustment could take time and may not fully compensate for imbalance. As a result, the immediate impact of a border adjustment tax on businesses that rely heavily on imports could be significant.”