How Tax Reform Framework Impacts Traders And Investors

September 29, 2017 | By: Robert A. Green, CPA



On Sept. 27, the Big Six tax writers released an updated Unified Framework for tax reform making concrete steps forward on corporate and individual tax rates. As expected, they left many details and decisions to Congress on which deductions, credits, and industry-specific tax incentives to repeal to offset the massive reduction in tax rates granted to corporations and pass-throughs (PTE). Over the coming months, tax lobbyists will inevitably hover over tax writers like bees. Until we see the final bill, it’s hard to assess its impact on traders and investors.

Capital gains and investment income tax cuts retracted
I searched the nine-page framework document and was surprised not to find any mention of capital gains. I find that odd considering earlier blueprints promised investors lower capital gains rates on “all” capital gains, dividends, and interest income. “All” includes short-term capital gains and non-qualifying dividends. At first, I wondered if it was an oversight, or because they felt it was unworthy of inclusion in the overview. I became concerned they may have scrapped these tax cuts for traders and investors since they have to scale back some tax cuts for budget reconciliation. I confirmed my suspicions when I saw the following tweet after writing this article: Wall Street Journal tax journalist, “Richard Rubin (@RichardRubinDC) 9/28/17, 11:54 AM @SpeakerRyan on lack of capital gains tax cut: You just can’t do everything you want to do.”

Comparing the framework to earlier versions
BNA’s Comparison Chart of Trump Tax Plan and House Republican Blueprint is an excellent resource. According to “Savings and Investment Income” on p. 3:

Current law: “Long-term capital gain and qualified dividends taxed at rates of 0%, 15%, and 20%. (Top rate plus NIIT equals 23.8%.) Short-term capital gain, interest income and non-qualified dividends taxed at ordinary rates.”

Trump campaign tax plan: “Maximum rate of 20%.” (Current law.)

Trump administration tax reform outline: “Not specifically addressed.” (This omission was the first indication they were backtracking.)

House Republican Blueprint: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” The House Blueprint A Better Way “provides for reduced tax on investment income. Families and individuals will be able to deduct 50% of their net capital gains, dividends, and interest income, leading to basic rates of 6%, 12.5%, and 16.5% on such investment income depending on the individual’s tax bracket.”

The new framework doesn’t mention any of these provisions. It only states: “The committees also may consider methods to reduce the double taxation of corporate earnings.”

The new framework omits mention of “carried interest” tax breaks for hedge funds and private equity firms. Does omission indicate they are backtracking on a repeal of this tax break? Perhaps not, as it may not have been worthy of mention since the broad statements about closing industry-specific tax breaks may include carried interest. Hedge funds and private equity have significant lobbying efforts in D.C. Carried-interest for hedge fund managers is like sweat-equity for founders of start-ups.

Pass-through vs. corporations
The new framework’s top tax rate for corporations is 20%, PTE 25%, and individuals 35%. Taxpayers and their advisers will want to consider reorganization to maximize tax benefits. It would be nice to know all this before year-end to reorganize by the start of 2018.

The framework narrowed the definition of which businesses may qualify for the PTE rate: “The business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations.” Traders, eligible for trader tax status (TTS), are small, family-owned businesses.

The framework also calls for measures to prevent abuse of the PTE rate: “the committees [i.e., Ways and Means, and the Senate Finance Committee] will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” We have to wait for the committees to define “wealthy” in this context. I hope the tax writers don’t consider TTS trading gains as personal income rather than business income.

When the prior framework was released, journalists jumped on the fact that individuals would recast themselves as PTE or corporations to avoid the higher individual rate. Independent contractors are already a significant trend for employers to avoid payroll taxes, unemployment insurance, and employee benefit plans. Employees like the business status to deduct business expenses, reducing income taxes and self-employment taxes.

Treasury Secretary Stephen Mnuchin recently suggested service companies, like accounting, law and financial firms, shouldn’t be eligible for the PTE rate. I disagree. Service companies could recast as software-to-service or house intellectual property in a corporation to collect royalties rather than service revenues. Congress should not be picking winners and losers and penalizing service companies who are stellar performers in the American economy with tremendous job creation. Congress should keep the PTE rules straightforward and easy to enforce in the interests of tax simplification.

Some tax writers floated the idea of a 70/30 split of wage income vs. business income as a way to prevent abuse. For example, if an S-Corp has a net income before officer compensation of $1 million, the IRS would require the owner/officer to have “reasonable compensation” of $700,000, subjected to the individual rate up to 35%. The net income of $300,000 would be business income subjected to the PTE rate up to 25%.

With this labor/capital split, the effective PTE rate would be 32%.

This is calculated as follows: (70% wages x 35% individual rate) + (30% business income x 25% PTE rate) = 32% (only 3% less than the top individual rate of 35%). The Obamacare Medicare surcharge of 3.8% applies on the $700,000 of wages, which could negate much of the PTE tax benefit in an S-Corp. With a 70/30 split, many taxpayers may not find much tax savings using a PTE. If the committees use percentage allocation, I hope it’s more like 50/50. Perhaps, a corporation is better.

A trading S-Corp only wants enough officer compensation to unlock a retirement plan deduction, and IRS rules for reasonable compensation don’t apply since the entity does not have earned income. We don’t know yet how tax reform may impact trading companies. If they must use a 70/30 split, traders might have to report more compensation than they want, which triggers more payroll taxes and the individual rate. We don’t even know if the IRS will allow traders to be eligible for the PTE rate on trading income including Section 475 ordinary income. We also need to confirm that retirement plan and health insurance deductions will still be permissible for trading companies in 2018.

There is another glaring omission in the new framework: the health insurance premium deduction in a PTE. The framework repeals medical itemized deductions, but it does not address health insurance premiums deducted from adjusted gross income (AGI). “The framework retains tax benefits that encourage work, higher education and retirement security.” In prior blueprints, they included health insurance premiums next to retirement deductions.

I don’t expect the final bill to address trading businesses, as current law is shy on these issues, too. The IRS has to codify the legislation and write regulations, and that will take a long time. Traders should consult their CPAs and tax attorneys.

With reasonable compensation rules for a PTE, and perhaps none for a corporation, it could make the corporate structure more attractive. The devil will be in the details of final legislation, and tax writers better carefully think out incentives and “Freakonomics,” how incentives sometimes have the reverse effect. To date, corporations have been a bad choice of entity for a trading business due to double taxation, no pass-through of trading losses and expenses, no lower 60/40 rates in Section 1256, and more. Corporations have been good as management companies.

Budget reconciliation
Congressional tax writers are under enormous pressure to whittle down earlier vows to squeeze trillions of dollars in tax cuts into a 1.5 trillion-deficit placeholder negotiated for the 2018 budget. They scheduled the budget vote for Oct. 5, 2017. The Big Six plan to use “budget reconciliation,” affording them a majority vote procedure for Senate Republicans to pass tax reform and cuts without any support from Democrats.

Senator John McCain (R-AZ), who voted “no” on both health care repeal and replace bills, said the main reason was he wants “regular order” which requires a bi-partisan 60-vote cloture vote, and he recently said the same goes for tax reform. Senator Bob Corker (R-TN) told reporters, “What I can tell you is that I’m not about to vote for any bill that increases our deficit, period.”

In a letter to Republican leaders, 45 of the 48 Democratic senators requested bi-partisan negotiations, stating Republicans should not use budget reconciliation to pass tax reform. Democrats wrote they wouldn’t support tax cuts for the top 1% and they don’t agree on deficit-financing to pay for tax cuts.  Despite President Trump’s rhetoric about tax cuts not helping him and his family, and other billionaires in the top 1%, it’s not the case.

The effective tax rate for billionaires is close to the long-term capital gains rate of 20%, 15% before 2013. Long-term capital gains are their primary source of income, as many don’t take much compensation. These billionaires pay AMT because the AMT rate of 28% is higher than the long-term capital gains rate. To limit AMT and avoid estate taxes, many billionaires contribute significant amounts of their net worth to charity. The framework repeals AMT and estate tax, which is a massive tax cut for billionaires, including President Trump and his family. The framework doesn’t mention “step-up in basis” rules where heirs can avoid capital gains taxes. Billionaires and the wealthy own valuable corporations and pass-through entities so they will get lower tax rates on that front, too.

AMT and state and local taxes
If Congress repeals AMT, the second tax regime intended to ensure that wealthy taxpayers pay their fair share, it makes sense to repeal state and local taxes, which are one of the largest AMT preference items. To repeal the deduction alone would unlock much greater deductibility since AMT would no longer put a cap on it. That would wind up being a tax cut, rather than a tax increase, as intended. There’s already been significant blowback from members of Congress in high-tax states. Leadership is bending to that pressure. Will a tax increase turn into a tax cut on this measure? Or, will tax writers retain state and local tax deductions and AMT, too. Closing this deal will be tough.

There are a few other things I don’t like about the new framework. As with previous blueprints, it’s heavy on marketing content to convince working people that tax reform is for them rather than wealthy individuals and companies. I don’t like the double-talk. For example, the framework makes a big deal about lowering the top individual tax rate to 35%, but then it empowers tax writers to add a new higher rate without giving any details. It states it’s converting to a “territorial tax system” from a “worldwide tax system,” no longer taxing American companies abroad, but then it introduces a minimum tax on global income.

Timing and tax planning
The framework’s only retroactive provision is “full expensing,” active on the framework-date of Sept. 27, 2017. Other provisions won’t take effect until 2018. The Big Six is encouraging businesses to purchase equipment and other deductible assets before year-end to spur growth in the economy. It will help them argue growth pays for the tax cuts rather than deficit spending. The budget gives Republicans in both the House and the Senate a deadline of Nov. 13 to release legislative text on tax reform.

I am anxious to read final tax reform legislation so we can start crunching numbers to determine the winners and losers and help clients with tax planning for 2018. There will be surprises in the outcomes, “believe me.”

Taxpayers should commence 2017 year-end tax planning with the assumption that Obamacare taxes remain in place, only tax reform’s “full expensing” may start Sept. 27, 2017, and otherwise, tax reform, if passed, won’t be active until 2018.