News & Events
2017 Tax Reform
January 20, 2017
With both President-elect Trump and Congressional Republicans calling for tax reform, the likelihood of significant personal income tax legislation being enacted in 2017 is high. This legislation may encompass rate reductions, including capital gain rates, and numerous other changes, such as the elimination of the deduction for state and local income and real estate taxes. The problem for individual taxpayers is, of course, how to plan for 2017 and beyond since the nature of the tax changes and their timing is unknown.
A little history will help. President Reagan’s initial tax bill was enacted in August 1981 and included significant rate reductions phased in over a four year period from 1981 to 1984. The Tax Reform Act of 1986 was enacted in October 1986 and its dramatic changes in the rate structure were phased in during 1987 and 1988. President George W. Bush’s initial tax bill was enacted in June 2001 and its rate reductions were phased in over six years from 2001 to 2006. President Clinton’s signature tax bill, which increased rates, was enacted in August 1993 and was retroactively effective to January 1, 1993; the retroactivity of this legislation was upheld in the courts. This history suggests that we are not likely to know until mid-2017, at the earliest, what the new tax landscape will be, and it also suggests that any rate reductions will be phased in.
Given the complexity of the legislative process, it is normally a fool’s errand to try to predict changes in federal tax law. This year, however, may be somewhat different in that House Republicans released a comprehensive blueprint for tax reform in June 2016 and the Trump campaign has provided an outline of tax changes that it favors. The House blueprint and the Trump outline are identical in some respects and different in others.
A key feature of both plans is a compression of the current seven income tax brackets (with top rates of 35% and 39.6%) to only three (12%, 25% and 33%). Both plans eliminate the alternative minimum tax, which is extremely complicated but which in essence operates as a tax of 26% or 28% on gross income. Both plans also eliminate the net investment income tax, which is the 3.8% tax on all forms of investment income even if the income does not benefit from favorable tax rates (such as interest, short-term capital gains and royalties).
The plans do, however, have significant differences. The House blueprint eliminates all itemized deductions other than the deductions for home mortgage interest and charitable contributions. The Trump plan preserves all itemized deductions but subjects them to a dollar cap of $100,000 for single taxpayers and $200,000 for married taxpayers.
Another key difference between the House and Trump proposals relates to dividends and long-term capital gains. The House blueprint reduces the top dividend and capital gain rate from 20% to 16.5%, whereas the Trump proposal keeps the top rate at 20% for capital gains (and apparently for dividends also). If the House proposal is adopted and the 3.8% net investment income tax is eliminated, the top rate for capital gains will drop from 23.8% to 16.5%, a significant reduction of 7.3 percentage points (a reduction of over 30%).
The House blueprint contains two potentially significant changes. First, interest will be taxed at the same preferential rates as long-term capital gains and dividends. Second, the business profits from Subchapter S corporations, limited liability companies and other pass-through entities, calculated after reasonable compensation is paid to the owners, will be taxed at 25% rather than, as under current law, the higher rates that might otherwise apply to the owners. The Trump plan makes no change with respect to interest but would allow pass-through entities to elect to be taxed at the entity level at the Trump-proposed 15% corporate rate.
Although tax reform seems likely in 2017 and the House and Trump plans provide a general indication of the type and degree of possible changes, it is virtually impossible to handicap, at least at this early stage, what the exact changes will be. For example, although both the House and Trump plans call for repeal of the 3.8% net investment income tax, this tax was enacted as part of the Obamacare legislation and its repeal, even if it happens, might be delayed if key parts of Obamacare are not immediately eliminated but are phased out over a period of time.
In addition to uncertainty as to the type of changes that might be made, there is uncertainty as to the effective dates of those changes. Given the history previously described, our best guess is that the rate changes will be phased in over a period of two or more years, most likely starting in 2018.
From a planning perspective, the best approach at the moment seems to be to keep a careful eye on Washington and, to the extent cash flow needs allow, to consider deferring income into the future, whether that income is compensation, business income from a pass-through entity, proceeds from the sale of a business, or other form of income. Solely from a tax standpoint, there would seem to be little risk to high income taxpayers (i.e., those currently in the 35% or 39.6% brackets) from deferring income since it is difficult to envision a scenario in which they would pay more tax by deferring than if they were taxed on the income in 2017.
Although tax planning is important, it is nevertheless imperative to keep in mind that all business and investment decisions should be made on the basis of their intrinsic merits and should not be driven solely by tax considerations. If, therefore, it makes sense from an investment perspective to sell a security in early 2017, the security should be sold since delaying the sale in the hope of benefitting from a possible tax rate reduction later in the year may prove to be a poor investment decision.
Finally, this brief overview of possible 2017 tax reform legislation is intended for general informational purposes. It is not intended to be a comprehensive guide to the type of tax changes that might be enacted this year and should not be relied upon as definitive advice. Each taxpayer’s situation is different, with unique considerations, and you should always consult with your personal tax advisor before making any decisions with respect to tax planning.