September 29, 2017 Tax reform framework would repeal AMT and estate tax, eliminate all individual deductions except home mortgage interest and charitable donation The Trump Administration, the House Ways and Means Committee and the Senate Finance Committee have released a "unified framework" that will serve as the basis for developing tax reform legislation. Key aspects of the framework affecting individual taxpayers include: — An increase in the standard deduction to $24,000 for married taxpayers filing jointly and $12,000 for single filers — Elimination of personal exemptions for the taxpayer, spouse and dependents — Three (as opposed to seven) income tax brackets for individual taxpayers — 12%, 25%, 35% — with the possibility that an "additional top rate may apply to the highest-income taxpayers" — An increase in the child tax credit, along with an increase in the income levels at which the credit phases out — A new nonrefundable $500 credit for non-child dependents — Repeal of the individual alternative minimum tax (AMT) — Elimination of most itemized deductions, retaining only the home mortgage interest and charitable contribution deductions — Repeal of most individual exemptions and credits — Repeal of the estate tax and the generation-skipping transfer tax (GST) — Retain tax benefits aimed at encouraging work, higher education and retirement savings Implications Income tax matters Directionally, the "unified framework" is consistent with prior releases by the Trump Administration and the House GOP. The mantra of "broaden the base and lower the rate" is still very much alive. In the individual context, the broadening of the base seems to be accomplished through eliminating deductions and credits — the most notable of which is the state and local tax deduction. The charitable deduction and mortgage interest deduction, however, appeared to survive the cut. Although the headline marginal rates of 12%, 25% and 35% look appealing, specifics on the income level for which each rate bracket applies have been left to the Senate Finance and House Ways & Means Committees. This missing piece makes it difficult to conclude how tax reform may affect individual taxpayers. Although tax code simplification is mentioned, it is unclear how broad the simplification may be. Of course, rolling the personal exemption and into the increased standard deduction simplifies tax compliance, but the exemption is then replaced with a credit for non-child dependents. Similarly, any potential simplicity gained by the potential elimination of most itemized deductions will likely be replaced with complexity of another kind. For example, lowering the rate for pass-through income to create some sort of parity with corporate business income will likely require complex anti-abuse measures to ensure personal income (and likely investment income) is not characterized as business income. Immediate expensing would be allowed "for the cost of new investments in depreciable assets other than structures made after September 27, 2017, for at least five years," though the committees are invited to further enhance expensing. Under the framework, the deduction for net interest expense "incurred by C corporations" would be limited, with the tax-writing committees instructed to consider the appropriate treatment of interest paid by non-corporate taxpayers. For business owners operating in pass-through form, the tax benefit of expensing and any business interest deductions may be limited to the 25% rate. Of course, the benefits of immediate expensing may be tempered by the at-risk and passive activity loss rules. For interest paid by non-corporate taxpayers (other than mortgage interest), there are already limits in place for investment interest notably similar to what is envisioned by "net interest" for corporations. The repeal of AMT, if realized, will be cause for much rejoicing. Of course, taxpayers who are usually subject to it are those with large state tax deductions and miscellaneous itemized deductions. Because those are probably on the chopping block, the repeal of AMT is mostly symbolic. Nonetheless, the elimination of the sheer volume of additional tax return pages due to repeal of the AMT would be welcomed by taxpayers, accountants, and the government. Taxpayers with unused AMT credit carryovers, however, will need to make their presence known to assert that elimination of the AMT shouldn't also eliminate their unused credit carryforwards. Elimination of the personal exemption (rolling it into the standard deduction) means that nonresident aliens working in the US would be taxed on their first dollar of income. They are not entitled to the standard deduction, but may claim a personal exemption against their wages under current rules. And, under current law, if they work in the US only a very short time and earn less than the personal exemption amount for their US workdays, they don't even have to file a tax return. Under the new framework, they would have to file to pay approximately $500 of US tax. Transfer tax matters Although the "unified framework" would repeal the estate and GST tax, no mention is made of the gift tax. Thus, it should be presumed that the gift tax will remain in effect. If the gift tax remains in effect, how will it work if the estate and GST are repealed? Some insight might be gained by looking back to the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act), in which the estate and GST tax were similarly repealed (over the reconciliation period of 10 years) and the gift tax remained in effect. The 2001 Act provided a: — Gift tax at graduated rates up to 35% — Gift tax exemption of $1 million — Modified carryover basis (modified because, at death, the estate could add an allowance of $1.3 million to the carryover basis of the assets held by the decedent at death ($3.5 million for transfers to the decedent's surviving spouse)) The Act also allowed the holding period for property held at death to be tacked to the decedent's holding period. Bills similar to the provisions in the 2001 Act have been already been introduced in 2017 in the House and Senate (H.R. 631 and S. 205), providing: — Repeal of estate and GST taxes — Graduated rates up to 35% (after $500,000) for gift tax — A gift tax exemption of $5 million (adjusted for inflation after 2011) The current bills do not address issues regarding the basis or holding period of capital assets held by the decedent at death, which is still somewhat up in the air. Releases by the President during his campaign indicate that there will be something like modified carryover basis or a deemed sale of the capital asset held at death (which would trigger a capital gains tax at death), with an allowance of up to the first $10 million of gain recognized due to the deemed sale at death. The dog that did not bark1 The "dog that did not bark" is a witty canon of statutory interpretation that presumes a prior legal rule should be retained if no one in legislative deliberations mentioned the rule or discussed any changes to the rule. This quirky canon has even been applied in the tax world.2 With that background, the question becomes — what dog did not bark on September 27? First, and foremost, there was no mention of repealing the net investment income tax or the additional Medicare tax, both of which were created to fund the Affordable Care Act. Second, there was no mention of reforming carried interest (but it was mentioned several times by White House officials on September 28). Third, there was no mention of repealing the tax imposed by Section 2801 on gifts and bequests from covered expatriates. And finally, there was no mention of changing self-employment tax. There was also was no mention of the downstream applicability of these broad tax reform brush strokes on the income taxation of trusts and estates. The elimination of itemized deductions and the reduction of the marginal rates was not mentioned in this context. The entire framework of income taxation of trusts and estates is built on the back of itemized deductions. Was this overlooked or just another dog that did not bark? Of course, the most glaring omission was a proposed effective date of the "unified framework," although the dog-that-did-not-bark canon likely does not apply in this context. One analogy that comes to mind is children asking their parents when dinner will be ready, only to be told, "When it's done cooking." The tax reform oven in Washington is heating up — we have to be vigilant about watching through the oven door to best predict when the tax reform chicken's timer will pop up. ———————————————
——————————————— 1 "Is there any point to which you would wish to draw my attention?" "To the curious incident of the dog in the night-time." "The dog did nothing in the night-time." "That was the curious incident," remarked Sherlock Holmes. — Arthur Conan Doyle, "Silver Blaze (Adventure XIII)," Memoirs of Sherlock Holmes, 1892 2 Church of Scientology of California v. Commissioner, 484 U.S. 9 (1987). | |||||||||||||||||||
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