Strategies for tax changes under the Trump administration
by Kris YamanoMs. Yamano is vice president and regional leader of wealth planning with BMO Private Bank. Visit www.bmo.com.
On the topic of tax reform under a Trump administration, one thing is certain – change is coming. Despite concern from some critics about how President-elect Trump’s tax cuts and spending plans may increase the federal deficit, it appears likely that with a Republican majority in both houses, some of the big tax cuts promised by Trump during his campaign may come to fruition.
Whether Trump’s proposals will actually benefit middle-class America is up for debate and remains to be seen. In the meantime, let’s review what tax policies are currently on the table for change and some related planning considerations for taxpayers.
Individual Income Tax
The President-elect’s proposed tax plan calls for a consolidation of the current seven income tax brackets (ranging from 10 – 39.6 percent) into just three – with ordinary income tax rates to be set at 12 percent, 25 percent and 33 percent. The capital gains rates would remain the same, but the brackets would be adjusted (to mirror the ordinary income tax brackets).
Trump’s plan eliminates both the 3.8 percent Net Investment Income (NII) Tax and the 0.9 percent Additional Medicare Tax on high-income taxpayers that was enacted under the Affordable Care Act. It also promises to completely eliminate the alternative minimum tax for individuals. From a planning perspective, individuals should work closely with their financial planners and tax advisors to review their current tax bracket and obtain an understanding of their anticipated tax bracket for 2017.
Acceleration or deferral of income/deductions should be considered in order to maximize the potential shift in tax brackets and rates. Taxpayers will also have to weigh whether to defer capital gains until next year in anticipation of the NII repeal on the one hand, or potentially reap gains this year since the 20% capital gains tax rate will apply to those at a lower income threshold in 2017.
There are a few other proposed changes taxpayers should note as well. Trump’s tax plan aims to increase the standard deduction from $12,600 to $30,000 for married couples filing jointly – and from $6,300 to $15,000 for single filers. It would eliminate the personal exemption and allow most Americans (individuals earning $250,000 or less; or couples earning $500,000 or less) to take an above-the-line deduction for the average cost of child or elder care. In addition to the above-the-line deduction for child or elder care, Trump’s plan would permit the creation of tax-deductible, tax-free savings accounts for these expenses, which could include a matching component by the government.
Some of the changes to the individual income tax regime could, according to some sources, result in a significant reduction in federal tax revenue over the next decade. In order to mitigate this loss in tax revenue, Trump’s plan calls for itemized deductions to be capped at $200,000 for married couples filing jointly and $100,000 for single filers. From a planning perspective, individuals that are high income earners and normally itemize their deductions may want to consider accelerating as many of these deductions as possible into 2016, when they are likely subject to a higher tax bracket and not limited to the proposed caps.
Individuals who normally have deductions under the new standard deduction amounts can look forward to simpler tax reporting and may not have to keep track of their charitable donations and other miscellaneous deductions. On the flip side, some critics argue that an increase in the standard deduction takes away the incentive of the middle class to take on mortgage debt or make gifts to charity, as they may no longer receive a significant tax benefit under Trump’s proposed tax plan.
One last thing to note on proposed individual income tax changes involves the taxation of carried interest. Under the current law, tax treatment of carried interest permits the General Partners of hedge funds, venture capital firms and private equity funds to qualify for capital gains rates on portions of their investment income. President-elect Trump proposes to tax carried interest at ordinary income tax rates. However, if the entity is structured as a pass-through (limited partnership or LLC), it could qualify for a special 15 percent business tax rate (to be discussed below), depending on its size.
Business Income Tax
One of the biggest changes to business income taxes under Trump’s plan is a reduction in the corporate tax rate from 35 percent down to 15 percent. Although subject to some debate, this reduced rate could apply not only to C corporations, but also pass-through operating entities, including S corporations and partnerships, as well as income earned as a sole proprietor or independent contractor.
Trump’s proposed tax policy also calls for the elimination of the corporate alternative minimum tax. From a planning perspective, it may be a worthwhile exercise for business owners to review their business entity structure to determine whether they may take advantage of the lower corporate tax rates proposed. Those taxpayers who are currently considered employees of a company may want to explore whether converting from employee to independent contractor status and reporting Schedule C income could result in significant tax savings.
Also of interest from a business perspective, Trump’s plan would impose a deemed repatriation tax on currently deferred foreign profits at a tax rate of 10 percent, effectively putting an end to the current law that permits the deferral of tax on profits held overseas until a company chooses to repatriate them. From a planning perspective, US businesses may have less incentive to move their tax residence to foreign countries as a result of lower domestic corporate tax rates and the elimination of deferral on foreign-source income.
Estate & Gift Tax
A complete repeal of the federal estate tax, which has been a longstanding item on the Republican agenda, is a real possibility and an important component of Trump’s tax proposal. Trump’s plan calls for the elimination of the Federal estate and gift taxes, but may disallow a step-up in basis on inherited assets in excess of $10 million.
An inability to utilize a step-up in basis or requirement to report capital gains at death could generate some limited tax revenue from America’s wealthiest families. On another note, in light of Trump’s election and the proposed repeal of the estate tax, the recently proposed Internal Revenue Code Section 2704 regulations- which aim to severely limit any valuation discounts used during intra-family transfers of wholly-owned businesses – may no longer be a threat.
However, it is worth noting that many analysts are unsure whether a total repeal could be passed – and still others doubt whether a repeal could ever be permanent. From a planning perspective, the crystal ball remains unclear. If Trump succeeds in completely eliminating the federal estate tax, many advanced estate tax planning techniques (including the use of irrevocable trusts, GRATs, IDGTs and family limited partnerships) may be deemed unnecessarily complex.
Racing to lock in valuation discounts before I.R.C. Sec 2704 regulations become final may end up being an exercise in futility. Whereas the focus has traditionally been to plan for the estate tax, taxpayers may become increasingly interested in estate planning as asset protection tool. Still, as so much uncertainty remains, prudent planning may involve transferring some assets out of the estate as a precaution for a future reinstatement of the estate tax.
Holistic wealth planning has never been more important than in today’s climate of tax reform uncertainty. The importance of working closely with a team of competent advisors to provide complete tax, legal and financial advice is critical in ensuring taxpayers are able to maximize any benefits of Trump’s proposed tax plans (and avoid any potential pitfalls).
Although it is not clear how far Congress will go in the area of tax reform or how closely aligned with Trump’s proposed plans any final legislation will be, American taxpayers can definitely expect to see some movement in tax policy in the near future and keep their eyes on the proverbial tax ball.