The President has published his FY2016 budget proposal, designed to give the middle class a badly-needed boost. The budget has several tax implications, which a recent article in Forbes outlined for us. Here’s a review of the tax proposals in the proposed budget.
- Reduce the Value of Certain Deductions and Tax-Exempt Income to 28% — Currently, individual taxpayers with taxable income in excess of $189,301 (if single) and $230,451 (if married) pay tax at rates of 33%, 35% and 39.6% on progressively increasing income. As a result, a taxpayer in the highest tax bracket generally gets a tax benefit of 39.6% for each claimed deduction. The new budget proposal would allow taxpayers in the 33%, 35% and 39.6% bracket to only receive a tax benefit equal to 28% of a claimed deduction. The President has suggested that the reduced benefit not apply to commonly-deducted items like charitable contributions, but only to items like interest income on state and local bonds. This action would result in $603 billion in additional tax revenue over the next ten years.
- Imposition of the Buffett Rule — There’s currently no law addressing this, but the President proposes a “Buffett Rule,” which would ensure that all taxpayers with adjusted gross income in excess of $1 million pay an effective tax rate of at least 30%. The term comes from Warren Buffett’s public announcement that he paid a lower tax rate than his secretary. The President’s proposal would add an alternative minimum tax calculation to the current individual income tax regime, which would effectively put an end to the preferential 20% maximum tax rate given to long-term capital gains and qualified dividends. This action would add $35 billion in additional tax revenue over the next ten years.
- Return the Estate Tax Parameters to 2009 Levels —The current law reflects a compromise where the estate tax exemption is at $5.12 million. However, the President would like to reduce the exemption amount to $3.5 million (not indexed for inflation) at a 40% tax rate. This action would result in $189 billion in additional tax revenue over the next ten years.
- Tax Carried Interest as Ordinary Income — First, let’s define “carried interest.” The managers of a private equity fund (a business that takes the pooled capital of a small group of investors and invests in various stock holdings) are compensated two ways. One way is that they receive a management fee (usually 2% of managed assets). The second way is that they receive a right to 20% of the future profits of the fund. This second method of compensation is referred to as “carried interest.” The current law has the fund manager recognizing no taxable income for those future profits. Because private equity funds are structured as partnerships, they avoid the rules for corporations which address future profit income. And because a private equity fund typically generates long term capital gains and “qualified dividends,” which are both subject to the preferential 23.8% tax rates currently in place, the partner will effectively pay tax on his “services” at a rate that is nearly 20% lower than the maximum rate on ordinary income.The President has proposed having the income that flows to a partner from a carried interest – regardless of its characterization at the partnership level – instead taxed as ordinary income. This action would add $18 billion in additional revenue over the next ten years.
- Close the S Corporation Payroll Tax “Loophole” — Under today’s law, S corporation shareholder-employees can often avoid payroll taxes by withdrawing income as distributions rather than compensation. The President wants to prevent that, although the proposed budget doesn’t outline exactly how. If the loophole were closed, it would add $75 billion in additional revenue over the next ten years.
- Decrease to Corporate Tax Rate — Current law taxes U.S. corporations at 35%, higher than any industrialized nation. The President’s proposal suggests lowering this rate to 28%, with a 25% effective rate for U.S. manufacturers. This would remove the incentive for U.S. corporations to take their operations offshore.
- Increasing Top Rate on Capital Gains and Dividends — While most Americans pay 0% or 15% tax on capital gains and qualified dividends, those with taxable income greater than $464,850 in 2015 (if married, $413,200 if single) are subject to a 20% rate, plus a 3.8% surtax on net investment income. The President’s plan would increase the maximum rate on capital gains and dividends rates to 28%, inclusive of the surtax on net investment. This new top rate would apply only to those taxpayers with taxable income greater than $500,000, or approximately .8% of the population. However, in 2012, the highest-income 400 taxpayers obtained 68 percent of their income from capital gains, so while the tax would be narrow in scope, it would be material in substance, to the tune of adding $208 billion in revenue over the next ten years, when taken in conjunction with the disallowance of the tax-free step up at death, discussed next.
- Disallowance of Tax-Free Basis Increase at Death — When a taxpayer dies, the heirs take a basis in the property equal to the property’s fair market value. The deceased taxpayer’s estate, however, does not pay tax on any appreciation inherent in the property. The President’s proposal would treat bequests and gifts other than to charitable organizations as if the property had been sold in a taxable transaction. The President’s plan comes with several caveats, exclusions and limitations meant to protect the middle class, including no tax due until the death of the second spouse, capital gains of up to $200,000 per couple ($100,000 per individual) could still be bequeathed free of tax, couples would have an additional $500,000 exemption for their primary residences ($250,000 per individual), tangible personal property other than expensive art and similar collectibles (e.g. bequests or gifts of clothing, furniture, and small family heirlooms) would be tax-exempt, no tax would be due on inherited small, family-owned and operated businesses, and any closely-held business would have the option to pay tax on gains over 15 years. As noted above, this action would be expected to raise $208 billion in revenue over the next ten years, when taken in conjunction with the increase to the capital gains rates as discussed immediately above.
- International Tax Reform — Currently, income of foreign subsidiaries of U.S. corporations is taxed under what is commonly referred to as a “deferral” system, meaning that the income earned by the foreign subsidiary is generally not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend. When the income does come back to the U.S., it is subject to a corporate tax rate of 35%. This deferral system provides tremendous incentive for U.S. companies to move foreign operations offshore, where they often pay a tax rate well below 35%, and then leave it there, which deprives the U.S. government of much-needed cash and U.S. taxpayers of much-needed jobs. It’s estimated that as much as $2 trillion of profits are currently housed offshore in foreign subsidiaries of U.S. corporations. The President is proposing an immediate, mandatory 14% tax on the purported $2 trillion of earnings U.S. corporations currently have stored overseas in foreign subsidiaries. This would translate into $240 billion instantly making its way into the government coffers. This tax would be applied even if the U.S. corporations don’t repatriate those earnings into the U.S. Then moving forward, the President would move to a hybrid-worldwide system, in which U.S. corporations would be required to pay a minimum corporate tax of 19% on income earned anywhere in the world, even if earned through a foreign subsidiary. This action would result in $268 billion in revenue raised from the one-time 14% tax, then $205 billion raised from the move to a 19% minimum worldwide tax.
- New Second Earner Tax Credit Where Both Spouses Work — The President is proposing to provide a new, second earner credit of up to $500. Families would claim a credit equal to 5% of the first $10,000 of earnings for the lower-earning spouse in a married couple, and the maximum credit would be available to families with incomes up to $120,000, with a partial credit available up to $210,000. This proposal would mean $89 billion in lost tax revenue over the next ten years.
- Expanded Child and Dependent Care Credit — Currently, a nonrefundable credit is available to taxpayers who pay child and dependent care expenses to allow the taxpayer (and spouse, if married) to work. The maximum credit is $1,200 for middle-class taxpayers with multiple children. The President’s tax proposal would increase the maximum child care credit for families with children less than five years of age, to $3,000 per child. The credit would be based on 50% of the taxpayer’s first $6,000 of pre-school or childcare expenses for each child under the age of five. Additionally, the phase-out of the credit percentage would be greatly liberalized: the 50% credit percentage would be available to families with incomes up to $120,000. This action would cost $50 billion in lost tax revenue over the next ten years.
- Revamp of Education Incentives — There are over 1,500 education incentives in today’s law, and many eligible taxpayers don’t take advantage of any of them because they’re a confusing mix of phase-outs, thresholds, and limitations. The President’s plan would eliminate and consolidate existing credit and deduction provision into one expanded American Opportunity Tax Credit (AOTC) of up to $2,500 each year for five years. In addition, the proposal would increase the refundable portion of the credit to a flat maximum of $1,500, and expand AOTC eligibility for non-traditional students. The proposal would also repeal the complicated student loan interest deduction for new borrowers. The cost would be $46 billion in lost tax revenue over the next 10 years.
- Financial Fee — The new proposal would impose a 7 basis point fee on the liabilities of large U.S. financial firms: the roughly 100 firms in the nation with assets over $50 billion. The intention is that this would lead them to make decisions more consistent with the economy-wide effects of their actions, which would in turn help reduce the probability of major defaults that can result in widespread economic disaster. This action would result in $111 billion in additional revenue over the next ten years.
- Increased Availability of Cash Method Accounting — Under current law, taxpayers with inventory and C corporations with average gross receipts over a three-year period in excess of $5 million cannot use the cash method of accounting. The President has proposed allowing all businesses with gross receipts less than $25 million to use the cash method. This action is estimated to cost $14 billion in lost tax revenue over the next ten years.
- Changes Coming to Corporate Distributions — The budget has a new item listed under “Other Revenue Changes and Loophole Closers” that reads, “Tax corporate distributions as dividends.” This appears to repeal the “boot-within-gain” rule that limits the amount of gain a shareholder in a tax-free reorganization recognizes under Section 356. In his budget, the President would put an end to this rule by effectively treating the entire $20,000 of cash received as a dividend, subject to certain rules and requirements.
Now, the question is, what chance does the President’s proposed budget have of passing? In a Republican-controlled Congress, the answer is zero. Other than the provision to decrease corporate tax rate, Congress would never agree to any of these proposals.