Surprising effects of tax reform
The election is over, and for the first time in many years one political party will control the executive and legislative branches of government. The time is ripe for tax reform.
President-elect Donald Trump laid out several tax proposals for his first 100 days in office and these proposals, for the most part, dovetail with the “GOP Better Way” tax reform blueprint. Although there are differences, the plans are close enough in several areas to give us a good idea of the direction of the change.
As far as changes to domestic business taxation, both the Trump and GOP plans propose the following:
Elimination of alternative minimum tax;
Elimination of certain deductions;
Cap on tax rate for pass-through active business income; and
Expanded expensing of fixed asset investment.
The Trump plan calls for a corporate tax rate reduction from the current rate of 35% down to 15%. The house plan also calls for a rate reduction, but only down to 20%. Both the Trump and the house plans call for the elimination of the alternative minimum tax.
The reduction in tax rate is tied to an expansion of the tax base. So while the rate of tax is less, taxable income may be more because both plans call for the elimination of targeted corporate tax expenditures. The Trump plan calls for the elimination of all credits, except the research and development credit, as well as the carried interest deduction and the domestic production activities deduction. The GOP plan goes a little further and limits interest expense deductions to offset only interest income. Any net interest expense can be carried forward indefinitely as a deduction against future interest income.
The limitation on the interest expense deduction may create some heartburn for President-elect Trump due to his real estate background. Generally, interest expense deductions are significant in the real estate industry and the restrictions on deductibility as stated in the GOP blueprint could increase the tax burden for this industry.
For example, a commercial rental building has gross rental income of $520,000 with total deductions of $500,000, including $90,000 of interest expense. The net income from the rental is $20,000. Under current law, tax due at the 35% tax rate will be $7,000. Under the GOP plan, interest expense is limited to interest income (in our example - assume zero) and taxable income will be $110,000. The tax rate is reduced to 20% and total tax on the rental will be $22,000. The elimination of the interest expense deduction coupled with the reduction in tax rate increases the tax due by $15,000.
The Trump plan calls for expanded Sec. 179 expensing from $500,000 to $1 million. The GOP plan calls for current expensing for all capital investments, both tangible and intangible. The Trump plan only extends unlimited investment expensing ability to manufacturing firms, and this is only in lieu of deducting interest expense.
Both the GOP plan and the Trump plan have tied unlimited expensing of fixed asset additions to an elimination of the interest expense deduction. According to the GOP blueprint, “the benefit of immediate expensing of business investment operates as a more beneficial and more neutral substitute for the deduction of interest expense associated with debt incurred to finance such investment.”
Using our previous example, assume that a new elevator was purchased at a cost of $100,000. This investment could be fully deducted bringing income down to $10,000 for total tax of $2,000.
The Trump plan changes tax structure for pass-through entities. Currently, all income from pass-through entities (S corporations, partnerships, sole proprietorships) is taxed at the individual owner level. Under the Trump plan, income retained in the business would be taxed at a 15% tax rate with distributions of these earnings subject to a second layer of tax similar to C corporation dividends. Income distributed to the owner would be taxed at the ordinary individual rates. The GOP plan also gives a tax break to active business income from pass-through entities. Under the GOP plan, the rate would be capped at 25% instead of the highest proposed individual rate of 33%.
In summary, both the Trump plan and the GOP plan strive to increase the business tax base by selectively restricting certain deductions and decreasing the corporate tax rate. Both plans favor increased expensing of corporate tax investments in fixed assets as well as intangible assets. There are differences, and how these will play out over the next year is anyone's guess.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at firstname.lastname@example.org