Despite recent reports to the contrary, the sky is not falling. The increasing anticipation—or concern—over fundamental tax reform will certainly be with us in 2017, and probably through 2020. Still, many are intrigued about the possibility of the Trump administration abandoning incremental quick fixes and making the refurbishment of the tax system a top priority; this would mimic the Obama administration’s passage of the Affordable Care Act to define its agenda. Executive and legislative leadership are becoming increasingly dedicated to turning their acorns of ideas into oak trees representing the next generation tax system.
Change, whether for better or worse, is challenging. Regardless of what happens, it will be up to CPAs to meet the challenge. Clients look to CPAs as their trusted tax advisors to guide them in changing times. No one can predict outcomes, but CPAs can and should evaluate the possibilities in order to be better prepared for whatever comes down the road.
Flaws of the Current System
While there are extreme differences of opinion concerning the solution, a reasonable consensus exists about the key problems in our current tax system and goals for reform:
- Complexity in the integration of regular income tax, alternative minimum tax, net investment income tax, Social Security tax, and Medicare tax
- Misaligned incentives in the international tax structure, affecting border adjustability and global tax competition
- Estate and gift tax regimes
- Complex tax incentives directing (or misdirecting) economic behavior and favoring some businesses and activities over others.
Fundamental tax reform’s long-term goal is to make everyone a winner through a more efficient system in a more prosperous economy. At the same time, the short-term perception of fairness is important. It is traditionally dominated by a discussion of tax equity, including a critical, credible analysis that the changes do not unfairly redistribute the tax burden among all economic classes.
Possibilities of Change
There is an eternal triangle in developing any tax policy, consisting of the conflicting goals of fairness, simplicity, and economic policy. The triangle gets even more complex in today’s politics because there are three superficially distinct points of view to take into account: 1) the tax elements of President-elect Trump’s “Make America Great Again” plan laid out during the campaign, 2) Rep. Kevin Brady’s (R-Tex.) House Ways and Means Committee’s “Better Way” Vision for a Confident America, released in June as an outgrowth of Rep. Dave Camp’s (R-Mich.) 2014 Tax Reform Act, and 3) the tax proposals embedded in the 2016 Democratic Party platform, notwithstanding the election results, which signal the future policy direction of the minority party.
As a practical matter, in spite of the Republican majorities in both houses of Congress and control of the White House, members in all three groups will likely need to work together to achieve fundamental change. Not surprisingly, the Trump platform and the Better Way plan are becoming increasingly aligned, and even certain Democratic tax reformers have already shown signs of alignment as well.
All three plans include solving the repatriation of the estimated $2 to $3 trillion of untaxed, offshore corporate income. Unlike most countries, U.S. tax policy has always taxed global income, but it tips its hat to the global system by allowing U.S.-organized corporations to defer recognition until the income is repatriated. Repatriating past corporate profits—but taxing them at much lower rates, and taxing future corporate profits at lower rates—are both key elements in the Make America Great Again plan.
President-elect Trump has also announced a tax strategy that would reduce the top individual rate from 39.6% to 33%, the corporate rate from 35% to 15%, and the flow-through rate for business from 39.6% to 15% for “retained profits.” A detailed definition of retained profits is a work in progress, but this could include a second tax upon distribution. Furthermore, the reduced rate would be accompanied by base broadening—for example, the elimination of the deduction for state and local taxes and caps on some or all itemized deductions. For many individuals and under many circumstances, the lower rate and broader definition of income subject to tax could result in the same tax cost.
There is an eternal triangle in developing any tax policy, consisting of the conflicting goals of fairness, simplicity, and economic policy.
The Better Way vision has suggested top individual rates of 33%, corporate rates of 20%, and flow-through rates of 25%—not far off from the Trump plan. The Better Way plan also includes a warning that the 25% rate applies to “business profits,” but would require a determination of reasonable compensation to any owner/operator. Whether reasonable compensation is defined as a percentage of profits (70% has been often suggested) or by using a complex facts and circumstances analysis are key items to watch as any tax legislation progresses. Furthermore, as tax practitioners understand, the tax base is equally—and often more—important as the tax rate. This plan at least partially pays for reduced rates by reducing or eliminating deductions, which is also part of Trump’s vision.
The Democratic Party’s platform has proposed a new version of the minimum tax, the politically popular Buffett Rule, which would create a 30% minimum tax rate and utilize higher rates for high earners (without going into specifics). Note, however, that the Democratic Party’s platform did not endorse Hillary Clinton’s 43.6% high-earner rate nor Bernie Sanders’s 52% rate. The absence of a rate in the actual platform, replaced by the broad statement that millionaires and billionaires simply must pay more, indicates internal disagreement and, perhaps, flexibility.
Areas of Common Ground
All three plans anticipate elimination of lower tax rates on carried interests, but they do not offer specifics about whose carried interest would be eliminated: Only investment or hedge fund managers? Real estate developers? Or all taxpayers? Revenue estimates of the impact vary widely depending upon whose carried interest is eliminated.
There is a strong public sentiment embedded in the Republican-controlled Congress and President-elect Trump’s plans to eliminate the current system of taxing wealth transfers under the current estate and gift tax system. President Obama’s last budget included a proposal to retain the current system to tax transfers and to tax unrealized appreciation on sale, but more moderate views have been expressed by some Democratic leaders.
Alternatives to the current system include a tax based on any of the following systems: 1) taxing the estate for untaxed gain at death, 2) eliminating carryover basis and taxing gain on the eventual sale of gifted or inherited assets, and 3) including any inheritance as taxable income to beneficiaries. All of the proposals have exclusion thresholds ranging from $1 million to $10 million, which would exclude most estates from taxation. Estate taxes were put in place over 100 years ago in a spirit of populism epitomized by Theodore Roosevelt’s Bull Moose Party. The longstanding estate tax system will not die quickly unless it is replaced with some kind of countermeasure.
Most tax laws that are enacted reflect a combination of ideas that have been on the shelf for years. The outline of reforms can be anticipated, but the potential details cannot.
The debate about the compatibility of a value-added tax (VAT) or PCT with state and local sales tax often overlooks a simple solution; integration. The federal government could assess a PCT at a somewhat higher rate, say 15%, and offer the states revenue-sharing for one third (5% of 15%) of all collections based on the destination of all goods sold. The system would not be mandatory, but in order to join the system the states would have to agree not to assess a sales tax. Even though the tax rate in this example is nominally lower than the highest state sales tax rates, elimination of administrative costs and ease of collection could produce significantly more revenues than the many, if not all, individual sales and compensating use tax systems in place at this time.
Both Republicans and Democrats have considered taxing consumption versus income. Sen. Benjamin Cardin (D-Md.) has advocated a Progressive Consumption Tax (PCT) based on the European value-added tax model. Businesses would collect the tax on all goods and services sold and receive credit for all taxes paid on their inputs. Exported goods pay no tax, but the manufacturer obtains a credit for the domestic taxes paid, while domestic consumers of imported goods pay a full PCT when goods are purchased. Many commentators regard these systems as incompatible with the current U.S. sales and use tax system, but a closer examination produces interesting food for thought (see sidebar for details). Sen. Cardin’s most recent rate proposal is 10% for PCT and 28% for the federal income tax, with an exemption from federal income tax for the first $100,000 of income for joint filers, $75,000 for heads of household, and $50,000 for singles.
As an example of the dynamics of the PCT, suppose that Mary pays a license fee to a software vendor of $200 plus $20 of PCT for each tax return she prepares and charges her clients $1,000 plus $100 of PCT as a fee. The $80 of net PCT is paid to the government by Mary, and Mary earns $800 taxable profit. Ignoring overhead allocations, and keeping in mind that if she is married the first $100,000 of joint income would be tax-free under the PCT, she would owe additional income tax of $224 at the highest 28% rate, and the government would collect a total of $324 of tax. Without the PCT, Mary’s current federal income and Medicare tax could be as high as 43.4%, or about $347. The tax burden in this simplified example is nearly equal, and the $23 difference is probably insignificant. It is worth noting that only approximately 84% of current federal income taxes are actually collected, leaving an estimated $400 billion uncollected per year. Higher compliance from a more effective system could easily make up any differential.
The Republican Better Way plan is a hybrid consumption and income tax, which would tax income at a lower rate. It also relies on a territorial system that only taxes in-country consumption through a destination-based tax regime. The plan would apply an income tax to domestic sales but exclude from tax the profits on export sales. The challenge to this system will be defining profits. A border-adjustable system of this sort has never been designed and will face increasing challenges. Technology such as cloud computing and services is making it increasingly more difficult to define a border. It also remains to be seen whether it would meet World Trade Organization criteria for fair border adjustability. Could an entity simply take the ratio of foreign sales over total sales and multiply it by taxable income to determine exempt income? No, that would be an income tax. Denying a deduction for imported goods, however, would have the same effect as a typical European VAT by creating a 20% tax cost increase on imported goods based on the corporate income tax rate in the Better Way plan, without creating an import tariff.
In addition to the challenges of border adjustability, the current system of worldwide taxation, whether income is earned directly or indirectly, is ripe for reform. Both the Democrats and the Republicans have long sought to find a way to reduce the erosion of the corporate tax system due to tax competition among nations. Both parties have identified accumulated, untaxed foreign profits as a ripe source for new tax revenues. The challenge will be finding an acceptable system to reach these policy goals. Everyone’s approach seems to be different, but solutions promise simplicity. For example, foreign tax credits would no longer be necessary if foreign income is either untaxed or taxed at a lower rate, which would surely contribute to simplification. Under a territorial system, antideferral regimes such as controlled foreign corporations, including the subpart F enforcement mechanism, could be trimmed down or eliminated.
What CPAs Should Do
Because whether fundamental tax reform is enacted in the next several years—and whatever form it might take—is unknown, CPAs should plan flexibly. Most tax laws that are enacted reflect a combination of ideas that have been on the shelf for years. The outline of reforms can be anticipated, but the potential details cannot. Flexibility in tax planning and tax structuring is critical when change is likely, and warning taxpayers that today’s plans must be adjusted for tomorrow’s rules sets the stage for planning opportunities when reforms are enacted.
Make plans cautiously.
Estate and gifting plans in particular involve long-term strategies; the current estate tax model is now 100 years old, roughly the same age many current taxpayers can expect to live. Some planners might take the chance to utilize the current $5,490,000 exemption now because it could be reduced or become irrelevant in a new system that taxes income rather than wealth transfers. Any transfers today should be cautiously evaluated for the likelihood of transfer remorse if the system does not change and the transfer no longer fits with the owner’s changing financial plans.
Put the tax law and proposed changes into context.
If a component of the change seems expensive, look for a balancing component. Many residents of California, New York City, and Hawaii have been distressed to learn that the state and local tax deduction could be eliminated in the Republican Better Way plan—but how many considered that the presumptive accompanying reduction of the maximum federal tax rate from 39.6% to 33% would create a nearly identical effective federal, state, and local income tax rate of about 46%? Furthermore, if the Medicare surtax and net investment income tax were eliminated, these taxpayers would pay even lower effective income tax rates.
Lastly, don’t panic! If there is fundamental tax reform and all the rules change, the skills and competencies that CPAs have spent their careers building will be the same ones they need to get to the next level, and guide taxpayers through the changes.