Tax reform with rate reduction may be a positive change for trading businesses conducted in pass-through entities, which may qualify for a new lower business tax rate vs. ordinary income taxed at higher rates. Before I tackle the details for traders, I discuss the likelihood of Congress passing tax reform in early 2017.
Few pollsters and tax advisers expected a Republican sweep of the election with Donald J. Trump winning the White House and Republicans retaining control of the Senate and House. Most tax advisers expected Hillary R. Clinton to win the presidency, the Senate to flip Democrat, and Republicans to maintain the majority of the House — continuing a divided government and tax-reform gridlock.
With the Republican sweep, some tax advisers and writers are forecasting the Republicans might use the nuclear option (reconciliation) to ram through their agenda, including repeal of Obamacare taxes and passing tax reform with tax cuts. I’m not sure I agree the Senate will use reconciliation for passing fundamental tax reform, yet it’s wise to consider tax planning just in case there is major tax reform in 2017.
Tax deferral at year-end 2016
If there’s going to be tax reform in 2017, it’s safe to assume it will include a reduction in tax rates. It’s probably wise to defer income and accelerate deductions for year-end 2016. Consider “tax loss selling” of investments and try to postpone business and other types of revenue until 2017. Conversely, if you are in a low tax bracket for 2016 and expect to be in a higher bracket in 2017, then do the reverse.
History of reconciliation used for tax cuts and tax hikes
Reconciliation is commonly referred to as the “nuclear option” because it “blows up” bi-partisan consensus in the Senate. Reconciliation is a drastic fast-track procedure that allows a simple majority of 51 to pass bills instead of the usual 60. The “cloture vote” of 60 Senators is needed to break a filibuster, which is the minority’s system of blocking legislation. It’s rare that one party has 60 Senators in their ranks, so a cloture vote encourages bi-partisan consensus.
The Republicans used Senate reconciliation to pass President George W. Bush’s tax cuts in 2001. The procedure requires a 10-year sunset provision. In 2010, President Barack Obama extended the Bush tax cuts for two years due to the recession, which led to the fiscal-cliff deal in 2012.
The Democrats used Senate reconciliation to ram through key tax elements of the Patient Protection and Affordable Care Act (Obamacare) in 2010, which poisoned the well for President Obama with Republicans and contributed to gridlock during the remainder of his two terms.
Will 51 Republican Senators support a reconciliation procedure?
Not all Republican Senators are on good terms with President-elect Trump. I’m not sure Republicans can count on votes from Republican Senators Lindsey Graham, John McCain, Jeff Flake and Ted Cruz in a reconciliation vote for Trump tax cuts, which are more aggressive than the House tax reform framework. Without their votes, the reconciliation measure won’t succeed. The Senate needs all 51 Republican Senators to pass a bill using reconciliation assuming all 48 Democrat senators vote no, which pundits expect. (There is a run-off election in Louisiana for one Senate seat.)
Trump’s tax plan is revenue negative
Tax scoring bodies declared Trump’s tax cut plan “revenue negative,” and they claim it will add significant amounts to the national debt. (Trump argues it should be scored dynamically based on a 4% growth rate.) I wonder if Republican Tea Party Senators (including Senator Ted Cruz) might object to busting the budget with Trump tax cuts, favoring the House tax reform framework instead, which scorers consider as more revenue neutral.
I expect Democrats to fight hard against tax cuts for the wealthy since they campaigned on tax hikes on the rich. Bush-like tax cuts, more extreme in rate reduction, will likely poison the well if passed in a reconciliation procedure with no Democratic support.
The House tax reform framework
In September 2016, Donald Trump revised his tax-cut campaign plan to be more in tune with Speaker of the House Paul Ryan and House Ways and Means Committee Chairman Kevin Brady’s tax reform framework “A Better Way: A Pro-Growth Tax Plan for All Americans.”
The Trump and House tax reform plans are similar in many ways, so it should be easy for Republican leaders to meld them together into one plan. Trump’s tax cut plan is more aggressive than the House by lowering the business tax rate to 15% vs. the House capped rate of 25%. That was par for the course for Trump, one-upping the House and being bolder.
The plans also differ on international tax changes, with Trump being more negative towards global corporations. Trump suggests taxing foreign income and repealing offshore tax deferral. The House is more global-centric, supporting international trade, too.
Small ball: Repatriate foreign earnings for infrastructure spending
There seems to be bi-partisan consensus to repatriate corporate foreign cash hoards at lower tax rates, to use those funds for infrastructure spending in America, with a “buy American” provision. But I’m not sure the Republicans want to play small ball now, with their perceived voter mandate and sweep. They may feel emboldened to ram through tax reform with tax cuts through reconciliation, instead.
Trading businesses may significantly benefit from tax reform
Trump and House tax plans provide meaningful tax-rate reduction for businesses, including those operating in a pass-through entity including an LLC, partnership, and S-Corp.
The Trump tax plan mentions the 15% business tax rate is for “all businesses, both small and large, that want to retain profits within the business.” I need to see further details to resolve open questions. Is the 15% rate for undistributed profit only in a pass-through entity? Schedule C sole proprietor businesses do not currently account for distributions, so will they be treated differently from pass-through entities?
Hopefully, like other businesses operating in a pass-through entity, a trading business will be able to qualify for Trump’s 15% business tax rate or the House’s 25% capped rate.
Both Trump and House plans reduce the top individual tax rate to 33% from 39.6% in 2016, which means the business tax rate will still be substantially lower than the individual rate (15% vs. 33%). This tax cut will incentivize taxpayers to create businesses, and generate business income, which is a good thing for job creation.
In the past, when Congress talked about reducing corporate tax rates, tax advisers cried foul, claiming small businesses don’t use a corporate structure but rather pass-through entities taxed at higher individual tax rates. (Anytime Congress talks about lowering corporate tax rates but not reducing individual rates for small business, it leads to distortion in tax planning. You can’t leave out small business pass-through entities and only do corporate tax reform.)
Both Trump and House plans reduce itemized deductions, repeal the alternative minimum tax and personal exemptions. That affects the effective tax rates.
Trader tax status and pass-through entities
To qualify for a preferential business tax rate, I guess a taxpayer will need to conduct his or her trading business in a pass-through entity, and the entity will have to qualify for trader tax status (TTS), which is business expense treatment. Further, the company may need to elect Section 475 MTM ordinary income or loss treatment, as capital gains in the entity may not qualify for the preferential business tax rate.
If the entity trades Section 1256 contracts, it may be attractive to file an election for Section 475 ordinary gain or loss treatment, forgoing the lower 60/40 capital gains rates, to qualify for the preferential business tax rate. The tax cuts may exclude capital gains in pass-through entities from using the business rate. Conversely, if the business rate is higher than 15%, some traders may fare better with Section 1256 60/40 capital gains, considering the lower capital gains rates (Trump plan) or preference excluding 50% of long-term capital gains, dividends, and interest (House plan). (60/40 means 60% is a long-term capital gain and 40% is a short-term capital gain.) Hopefully, tax reform won’t repeal 60/40 benefits.
If the tax cuts preclude a trading entity from the business rate, then perhaps a dual entity structure will work. A trading general partnership with TTS pays an administration fee and profit allocation to a management company that does qualify for the business rate. (Trump promised to repeal carried interest or profit-allocation tax breaks for hedge fund and private equity managers in his tax plan.)
The current tax strategy for business traders of paying reasonable compensation in an S-Corp to create earned income for employee benefit deductions may not be wise if all income is subject to the lower business rate, as paying salary converts business income to ordinary income.
Alternatively, if the business rate applies to undistributed income only, and the owner needs a salary to cover living expenses, then it may be wise for the S-Corp to continue with officer compensation and employee benefit plans. Salary and profit distributions may be taxable at ordinary rates.
Depending on how Congress writes the law, a partnership tax return might be better than an S-Corp since S-Corps are supposed to have reasonable compensation, which traders may seek to avoid to maximize use of the 15% rate. Partnerships don’t pay wages to partners; they use guaranteed payments, although a trading company should not have guaranteed payments.
Other good moves
There may be a rush of employees to qualify as independent contractors, which are sole proprietor businesses, so they also can utilize the preferential business tax rate vs. the higher ordinary rate on wages. (Sole proprietor contractors owe self-employment tax on net income, which includes FICA and Medicare.) That can encourage employees to become entrepreneurs.
Our firm is gearing up for possible tax reform, and we will stay on top of it for our clients. It could be a huge monkey wrench thrown into the tax code. That reminds me of another reason I don’t like the Senate nuclear option; it’s temporary tax changes, and that causes havoc in and of itself. Think Obamacare.
(For comparisons of the Trump and House tax cut plans, read Trump’s Tax-Cut Plans May Draw Congress to Art of the Deal and What Donald Trump’s Proposed Tax Cut Means For You.)
My partner Darren Neuschwander, CPA contributed to this blog post. Mr. Neuschwander expects the Republicans to use reconciliation to pass tax reform early in 2017.