Tax Reform Proposal Calls for Big Individual and Business Tax Cuts, and More

The Trump Administration and the Republican leadership in Congress have released a framework for tax reform on September 27, the "Unified Framework for Fixing Our Broken Tax Code." The framework calls for dramatic tax cuts and simplification: lower individual tax rates under a three-bracket structure, nearly doubling the standard deduction, and a significant reduction in the corporate tax rate; along with changing the tax treatment of pass-throughs, expanding child and dependent incentives, and more. Both the alternative minimum tax and the federal estate tax would be eliminated. This summary presents a high-level overview of the tax proposals and its impact on various groups of taxpayers.

INDIVIDUALS

Tax Rates

The framework calls for replacing and lowering the current individual tax rates with a new, three-bracket structure: 12, 25, and 35 percent. Under current law, individual income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent. The framework does not include proposed income ranges for the new brackets. This makes it difficult to determine whether taxpayers would see an increase or decrease in their effective rate even taking into account the effect of a higher standard deduction (discussed below). Only taxpayers currently in the 39.5 percent bracket can be assured that their applicable rate will decrease.

Standard Deduction

The plan calls for a near doubling of the standard deduction to $24,000 for married filing jointly and $12,000 for single filers. The 2017 standard deduction amounts under current law are $12,700 and $6,350, respectively, as adjusted for inflation. One goal of a higher standard deduction is to simplify tax filing by cutting more than half those taxpayers who would otherwise do better itemizing deductions. Of course, that group would realize less of a tax benefit than those taxpayers who do not now itemize.

Deductions

The framework would appear to eliminate all individual itemized tax deductions except for the mortgage interest deduction and the charitable contribution deduction. The framework would also eliminate "numerous other exemptions, deductions and credits," including the deduction for personal and dependency exemptions (discussed below). 

The loss of many itemized deductions would channel an even greater number of taxpayers to the standard deduction. Since the deduction for state income taxes and real estate taxes would be repealed, those who live in high-tax, high-cost jurisdictions, like California, will see their federal income taxes go up. A significant tax benefit of home ownership will also be eliminated.

Since the medical deduction would be eliminated, people who are uninsured or underinsured and pay for long-term care will lose a significant tax benefit.  Many seniors or those with costly medical needs will see their medical deductions go away. Miscellaneous itemized deductions are to be repealed. This will take away deductions from employees with large unreimbursed business expenses, divorcing individuals paying high legal fees, and investors with high investment management expenses. 

The doubling of the standard deduction would effectively eliminate most individuals from claiming itemized deductions other than high-income taxpayers. For example, if the standard deduction for married filing jointly is $24,000, then only individuals with mortgage interest and charitable deductions in excess of $24,000 would claim them as itemized deductions. With fewer individuals claiming those deductions, this could have broad impact on both real estate prices and charitable organizations.

Tax Credits

Despite this proposal to eliminate many deductions and credits, the framework does indicate that unspecified benefits meant to encourage work, higher education, and retirement would be retained. 

It is unclear from the text of the framework what exactly these unspecified tax benefits are, but it may include the earned income credit, the American Opportunity tax credit, deduction for tuition and fees, student loan interest deduction, and deductions and exclusions applicable to retirement savings contributions. Presumably, these details will be hashed out by tax-writing Committees in Congress.

Family Incentives

As noted above, the framework would eliminate the deductions for personal and dependency exemptions. This could lead some taxpayers to have higher taxable income even with the doubled standard deduction.

Under the inflation adjusted amounts for 2017, a family of four filing a joint return could claim a standard deduction of $12,700, plus $16,200 for four personal exemptions of $4,050. The result reduces adjusted gross income by $28,900. Under the GOP framework, the standard deduction for married filing jointly is only $24,000 with no exemptions. The result would be that the family's taxable income would be increased by $4,900 as compared to 2017 inflation adjusted amounts.

The framework indicates that the child tax credit would be "significantly" increased to help alleviate the discrepancy, though the amount of that increase is not specified. As under current law, the first $1,000 of the child tax credit (the so-called “additional child tax credit) would be a refundable credit. Also, income limitations on the child tax credit (currently $110,000 married filing jointly, $75,000 single, and $55,000 married filing separately) are also proposed to increase.

The framework also provides for a $500 credit for the care of non-child dependents. Under current law, taxpayers who incur expenses to care for a qualified child or for an incapacitated dependent or spouse to work or look for work may claim a credit of 20 percent to 35 percent of employment-related expenses. Depending upon income level and other factors, this can be as much as $2,100. It is unclear if the proposed $500 credit is in addition to the existing child and dependent care credit or a replacement.

Estate Tax

The President's proposal calls for elimination of the federal estate tax and the generation-skipping transfer tax. Very few Americans are currently subject to the federal estate tax at death. The exemption equivalent for 2017 is $5.49 million per individual, or nearly $11 million for a married couple.  The federal estate tax rate is 40% for the excess. (Note there is no proposal to repeal the federal gift tax.)

Alternative Minimum Tax

The framework calls for abolishing the AMT, calling it a complicated addition to the tax system that no longer serves its intended purpose. A parallel tax structure, the AMT, has existed for the stated purpose of ensuring that individuals, corporations, estates, and trusts with substantial income do not avoid tax
liability.  

Since the alternative minimum tax would be repealed, the exercise of incentive stock options would be deferred until the stock is sold or there is another disqualified disposition. The original tax benefit of incentive stock options would be restored.

BUSINESSES

Corporate Taxes

The framework calls for a 20-percent corporate tax rate. The maximum corporate tax rate currently tops out at 35 percent. The framework also calls for the elimination of the corporate alternative minimum tax.

Business Tax Benefits

A number of changes to various business incentives are proposed in the framework. Chief among them is effectively allowing 100 percent bonus depreciation for investments for a five-year period beginning in 2017. Currently, first year "expensing" of capital investments is limited to 50 percent of the cost, gradually stepping down to 30 percent for investments made in 2021.

Most economists have found that bonus depreciation does little in the way of motivating businesses to buy new equipment or property that they would not otherwise have bought; instead, bonus depreciation simply creates an incentive to accelerate already planned purchases to tax years when it is available.

Unclear under the framework is the fate of "section 179 expensing," which is available to small businesses on qualifying used as well as new assets. In perhaps a nod to the special needs of small businesses, the framework states that "the committee may continue to work to enhance unprecedented expensing for business investments, especially to provide relief for small businesses."

Additionally, the framework calls for the elimination of the domestic production activities deduction, indicating that manufacturers will no longer need the advantage of this deduction due to the substantial reduction in the corporate tax rate.

Pass-Through Businesses

Currently, owners of partnerships, S-corporations, and sole proprietorships pay tax at the individual rates, with the highest rate at 39.6 percent. The framework proposes a 25-percent tax rate for pass-through income.

Small business owners, therefore, would see their top tax rate reduced from 39.6 percent to 25 percent under the proposal.

U.S. multinational corporations

Under the proposal, dividends paid to U.S. corporations from offshore subsidiaries that are at least 10% owned by the U.S. corporation would be tax exempt.  U.S. corporations would no longer be subject to tax on their worldwide income, but only their U.S. operations. The lower corporate tax rate of 20 percent may also provide incentive for businesses not to shift operations overseas going forward.