25 October 2018 - Events
On Wednesday, Republican leaders released a nine-page framework for tax reform (the “Framework”) that they posit will end a pattern of ordinary Americans being “shut out of the dynamism of the US economy.” To date, significant legislative achievements in Washington have remained elusive, despite Republican control of the White House and both chambers of Congress.
The Framework is intended to generate much-needed momentum to unify the Republican Party behind a fiscal year 2018 budget resolution, which is a necessary springboard to preserve the budget reconciliation process. Indeed, the House Freedom Caucus, an influential block of conservative legislators that was withholding its support for a budget resolution pending agreement on tax reform principles, came out in favor of the initiative on Wednesday, noting that the group “looks forward to sending a final bill based on this framework to President Trump's desk as soon as possible.”
The Framework, developed by a group of Republican officials known as the “Big Six,” proposes slashing current tax rates to 20% for corporations, 25% for pass-through entities and a maximum of 35% for individuals, repealing the estate, generation-skipping transfer and alternative minimum taxes in their entirety, and cutting back or eliminating many popular tax incentives, including the deduction for state and local taxes. In the international field, the Framework calls for a transition to a territorial tax system for international businesses, with a two-part repatriation structure for existing offshore earnings.
Response to the Framework among Republican lawmakers has been favorable, although it should be noted that the Framework delegates most controversial decisions and details to the House Ways and Means and Senate Finance Committees, which are tasked with drafting the legislation. In many ways, the Framework represents modest progress over the House GOP tax reform blueprint released over a year ago (the “GOP Blueprint”), perhaps hinting that there are more significant disagreements among Republicans than public statements reveal. Immediate opposition from Democratic lawmakers, some of whom dubbed the proposal “wealth-fare,” further indicate that a substantial legislative fight is on the horizon. Senator Charles Schumer (D-NY) described the Framework as designed “to be cheered in the country clubs and the corporate boardrooms.”
The framework leaves open key procedural questions, most importantly how its tax cuts, priced by the Committee for a Responsible Federal Budget at $2.2 trillion dollars over the next ten years, will be paid for and whether and to what extent budgetary offsets will be able to facilitate its passage into law. This decision-making is also tied into a “dynamic scoring” process that is designed to simulate enhanced revenue targets based on growth stimulation caused by the bill's provisions. What follows is a high-level overview of some of the key provisions of the Republican tax reform Framework:
- Rate Structure and Standard Deduction. The Framework would consolidate the seven existing tax brackets into three – 12%, 25% and 35% – but does not identify the income levels at which each bracket would take effect. The Framework also permits the drafting committees to create a higher fourth bracket that would apply to wealthy individuals, an idea popular among members of the House Ways and Means Committee. The Framework rationalizes the increased rate for the lowest tax bracket (currently 10%) by nearly doubling the current standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly. The Framework also proposes a revised method of inflation adjustment for indexing tax brackets “and other tax parameters,” an intriguing concept that would presumably affect many portions of the tax code, including inflation adjustments to exemptions and exclusions from the estate and gift taxes.
- Credits and Deductions. Perhaps the most significant changes proposed for individuals are those to credits and deductions. The guiding principle of the Framework, to the greatest extent possible, is to eliminate “exemptions, deductions and credits for individuals [that] riddle the tax code,” including the popular deduction for state and local taxes, an item that is certain to spark fierce opposition from lawmakers from high-tax (and traditionally Democratic) states like New York and California. Some items spared from the prospect of repeal are the mortgage interest deduction, the charitable contribution deduction and tax preferences “that encourage work, higher education and retirement security.” The Framework also proposes increasing the child tax credit “significantly” (last year's GOP Blueprint would have increased it to $1,500) and establishing a non-refundable credit of $500 for non-child dependents.
- Alternative Minimum Tax. The Framework proposes the wholesale repeal of the alternative minimum tax. Serious doubts exist as to whether this repeal will materialize, both because of its budgetary cost (estimated by the Urban-Brookings Tax Policy Center at $413 billion over ten years) and the political cost associated with the repeal of a tax that primarily affects wealthy Americans (in 2015, $22.5 billion of the $26.4 billion in AMT collected was paid by those with incomes in excess of $250,000).
- Estate and GST Taxes. The Framework also proposes the wholesale repeal of the estate and generation-skipping transfer taxes. Like the GOP Blueprint and the proposal released during President Trump's campaign, the Framework is silent as to the fate of the basis step-up at death, one of the most generous tax benefits afforded to estate beneficiaries. It is worth noting that President Trump's budget calculations show increasing revenue collection from the estate tax over the next ten years, suggesting that repeal of the “death taxes” is included in the Framework primarily as a bargaining chip for future negotiation. Gift taxes will presumably remain intact, as it is clear that without a gift tax the shifting of assets for income tax purposes would be unchecked.
- Corporate Tax Rates. The Framework proposes a corporate tax rate of 20%, along with the elimination of the corporate alternative minimum tax. The Framework also gestures to the possibility of including a version of the corporate integration plan proposed by Senator Orrin Hatch (R-UT), which seeks to eliminate the double taxation of corporate earnings by providing a 100% dividends paid deduction. House Ways and Means Committee Chairman Kevin Brady (R-TX), a key architect of the Framework, has said that achieving meaningful and permanent corporate tax reform is the primary thrust of the current legislative initiative.
- Pass-Through Tax Rates. The Framework proposes a new system of taxation for certain pass-through entities. According to the Framework, the “business income” of “small” and “family-owned” businesses conducted as sole proprietorships, partnerships and S corporations would be taxed at a rate of 25%. Key to the administration of such a regime would be the definition of the phrases quoted above, and the Framework directs the drafting committees to adopt anti-abuse measures to “prevent the recharacterization of personal income.” The Framework is notably silent on the treatment of income generated by investment firms like hedge funds and private equity funds, which both President Trump and Treasury Secretary Steven Mnuchin have publicly said should be excluded from any such regime. President Trump has made numerous public proposals to eliminate the “carried interest loophole,” but there is no mention of carried interest in the Framework.
- Business Deductions and Credits. As in the individual tax realm, the default assumption of the business tax provisions of the Framework is the elimination of many business tax incentives, including the elimination of the domestic production deduction and a partial limitation of the interest expense deduction. Consistent with President Trump's campaign proposal, the Framework expressly proposes the elimination of industry-specific tax incentives. Notably, however, the Framework would retain the research and development deduction and low income housing credit.
- Expensing Capital Investments. The Framework proposes that capital expenses incurred by businesses in making new investments in depreciable assets other than real estate could be immediately expensed rather than depreciated over their standard useful lives. These allowances would survive for a period of at least five years so as to promote new investments in equipment and technology.
- Territorial Regime. The Framework proposes a shift to territorial taxation for American businesses, envisioning a 100% exemption for dividends received from foreign subsidiaries in which an American business owns at least a 10% stake. This change has the potential to significantly impact the manner in which internationally mobile capital is deployed, as business operations could theoretically seek out jurisdictions with a lower direct tax cost and still retain access to US investment and US markets. The GOP Blueprint would have pushed back against this behavior with the imposition of a border adjustment tax on imports. The Framework does not adopt such an approach, instead opting to propose something akin to a global minimum tax, which would apply to the foreign profits of US multinational corporations at “a reduced rate.”
- Repatriation During Transition. For US businesses that have accumulated earnings overseas under the current system, the Framework proposes a two-part system for repatriation, with illiquid assets being subject to a lower tax rate than cash or cash equivalents held offshore. The transition rule would permit payment of the tax over a period of years. The details of such a repatriation holiday, including the rates of tax and the parameters for classifying “illiquid assets,” will likely inform the extent to which US multinationals choose to participate.
The tax reform Framework, which has been positively received by Republican lawmakers, seems to represent a step forward in unifying the Republican Party behind significant legislation. Although Republicans, in the aggregate, control the legislative branch, they can afford few defections in the Senate and have had considerable difficulty generating consensus thus far. The ability of Republican leaders to maintain consensus through the legislative drafting process will be a key determinant in whether and to what extent the tax reform initiative is successful.
While some proposals set forth in the Framework, like the repeal of the federal estate tax, would reduce the need for certain wealth planning techniques (assuming such a repeal is permanent), the new income tax regimes proposed might provide significant leeway for creative and effective income tax planning going forward, particularly for internationally mobile individuals. In addition, the Framework does not envision the repeal of the gift tax, and careful planning will still be required to avoid unintentional gifts in family transactions. A permanently reduced corporate tax rate could also have the effect of triggering substantial restructuring exercises for businesses formed as pass-through entities, which have taken advantage of the tax bias for such structures that has been in place for over three decades.
James R. Brockway
Registered Foreign Lawyer
Jay H. Rubinstein