This exclusive Tax Alert provides expert insights on critical areas not mentioned in the President's recently released tax reform framework. This analysis highlights areas which may either complicate the reform process, represent potential sources of revenue to offset the cost of tax reform, or reduce the perceived benefits of reform.
Capital Gains and Qualified Dividends: The framework makes no mention of the current reduced rate of tax on capital gains and qualified dividends. They haven’t always enjoyed preferential treatment. In recent years, several tax reform proposals eliminated the preference or returned to an exclusion of some percentage of capital gains. This may be one of the items up for negotiation to keep the cost of reform down. As for qualified dividends, the framework aims to eliminate the double taxation of corporate earnings.
What this means for you: If eliminating the double taxation takes the form of a dividend paid deduction for corporations, individual taxpayers may pay tax on dividends at regular tax rates.
Carried Interest: Carried interests, sometimes called a “promote,” are the contractual rights of fund managers to share in the fund’s profits after the investors have achieved a certain return. This was a major issue in the presidential campaign, but the framework is silent on the taxation of so-called: “carried interest.” The outcome is likely dependent upon what happens in general with capital gains.
1031 Exchanges: With the possible demise of estate taxes, a favorite tax strategy for real estate professionals and investors, 1031 Exchanges will be more important than ever. The like-kind exchange, which is a deferral of the gain on the sale of a business or investment asset when it is exchanged for a like-kind asset, is another unmentioned topic in the Framework. Repealing it would raise in excess of $40 billion over 10 years. President Obama, in several budget messages to Congress during his presidency, proposed allowing up to $1 million annually per taxpayer of deferred gain from like-kind exchanges. Given that structures were excluded from the Framework’s full expensing concept, sales of real estate will probably still be eligible for like-kind exchange treatment. However, silence on the matter creates looming uncertainty.
Estate Tax Basis Step-up: Under current law, a decedent’s assets are stepped-up to fair market value upon death with no tax cost. For smaller estates which are not subject to tax, or larger but properly planned estates, this is a tremendous tax windfall. If the estate tax is repealed, this provision likely goes away. Earlier this year, President Trump suggested charging a capital gains tax on the deemed sale of these assets at death above a certain amount; however, this is not mentioned in the framework.
Gift Tax: There is no mention of gift taxes in the framework. Under current law, there is a unified gift and estate tax regime which means that taxpayers can either make gifts to their heirs while alive or pass assets to them upon death and the tax cost is the same.
What this means for you: If the estate tax is repealed but the gift tax remains, what will happen to the unified credit? Will it remain as it is or be reduced? Will there still be an annual gift tax exclusion? Reducing or eliminating either or both could cause some previously tax-free gifts to become taxable and potentially alter the advisability of lifetime gifting.
Employer Health Insurance Deduction and Exclusion of Employer Contributions: This is one of the largest, but hidden, subsidies in the tax code. Most Americans other than those on Medicare/Medicaid get their health insurance through work. The employer gets a deduction and the employer contribution is excluded from the employee’s income.
Additional revenue sources: In a 2014 tax reform package proposed by Congressman Dave Camp, the former Chairman of the House Ways and Means Committee, the deduction was limited and the tax benefit to the employee was capped for higher income individuals. Current congressional staffers have already indicated that they may rely on the Camp proposal as a source of revenue.
Self-Employed Health Insurance Deduction: If the taxation of employer based health insurance is changed, this deduction will likely be affected as well.
Pass-through Entities: Discussion has centered around the lower tax rate for income from pass-through entities and how Congress will keep individuals from abusing it. Several proposals have attempted to address this problem when the idea of a lower tax rate for pass-throughs was discussed in Congress or in presidential campaigns. They ranged from:
- Arbitrarily designating a portion of the income as services income by active participants in the business subject to individual income tax rates; or,
- Collecting the tax at the entity level and then taxing distributions to partners or S corporation shareholders as qualified dividends (see above).
Dividend Paid Deduction for RICs and REITs: Regulated Investment Companies (Mutual Funds) and Real Estate Investment Trusts are corporations which, if they follow special rules, are entitled to deduct dividends paid and reduce their corporate income tax to essentially zero. Is this one of the “special tax regimes” that the framework contemplates modernizing to better reflect economic reality? Will these be converted to flow-through entities and taxed at that reduced rate?
Taxation of Americans Abroad: The framework envisions moving to a territorial based system for US multi-national corporations, but mentions nothing about US citizens residing overseas. Will they still be subject to a citizenship based tax system or will the residency based tax system proposed last year be adopted?
We will be closely monitoring these and other issues related to tax reform. As developments warrant, we will reach out to you with further information. In the meantime, please feel free to contact your Friedman LLP professionals with any questions.
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