Love him or loathe him, Donald Trump is the president come January 20. That’s yuge for the affluent and their advisors when you layer in the GOP’s control of Congress. The most successful Americans would benefit handsomely under either Trump’s tax proposals or those promulgated by House Republicans in their “Better Way” tax-reform blueprint pushed last summer.
“For advisors, the biggest opportunity is starting the conversation with a client or prospective client,” says CPA-planner Greg Lane, a principal at WellFit Financial P.C., in Phoenix. “These proposals are of interest to people, they’ll want customized advice, and that’s how advisors provide value. We’re customizers,” Lane says.
But advising about taxes can be “like advising about the capital markets. One of the biggest struggles is to help clients make decisions based on logic versus emotion,” says Moss Adams’ National Tax Director Gary Stirbis, in Tacoma, Wash. “Clients may try to rush through transactions based on a potential change.”
Making sure clients sit tight right now is important because at this juncture, no one really knows what changes could occur. Part of the problem is that on the campaign trail, Trump’s contradictory remarks launched the greatest search for hidden meaning since the Beatles released Sgt. Pepper. Post-election, the inconsistencies have continued apace.
So we can’t know whether to take seriously what Steve Mnuchin, the Goldman Sachs alum picked for Treasury secretary, told CNBC on November 30. “Any tax cuts for the upper class will be offset by less deductions that pay for it. There will be no absolute tax cut for the upper class,” he said. That certainly doesn’t square with the promise on his would-be boss’s website that “every income group receives a tax cut.” Nor does it toe the line of the GOP blueprint.
Which raises another question. Which plan will be the starting point for legislation, Trump’s or the Republican party’s? Technically, tax legislation comes from the House of Representatives.
From a planning perspective, it’s important to know when these new tax laws might actually take effect. It could be soon given how, even before taking office, Trump racked up an impressive set of accomplishments, from saving American jobs (and simultaneously cutting corporate taxes!) to reaching out abroad.
Then again, moving a once-in-a-lifetime tax-reform bill through both chambers of Congress could prove to be a long slog. If a law isn’t enacted until autumn, “at that point it may be likely to take effect in 2018,” says Mark Luscombe, a federal tax analyst at Wolters Kluwer Tax & Accounting, an information company in Riverwoods, Ill.
Of graver concern for planners is the possibility that new legislation could self-terminate after 10 years. Remember the 2001 tax act? If Republicans lack the 60 Senate votes needed to avoid a Democratic filibuster, they would have to pass a budget reconciliation bill with at least 51 votes. Such a bill must expire after a decade if, like the 2001 law and the Trump plan, it’s projected to have a negative impact on government revenues beyond then. As for the GOP blueprint, “according to its authors [it] is largely revenue neutral using dynamic scoring,” an Ernst & Young report says.
Individual Income Tax Proposals
Both the presidential and congressional plans would axe numerous items from the Internal Revenue Code, including the notorious alternative minimum tax. Abolishing the AMT would aid clients with incentive stock options, says Boston CPA Michael Antonelli, a partner at Edelstein & Company LLP. Exercising these options triggers AMT consequences that can prove disastrous if the stock’s value subsequently drops. “Eliminating the AMT would allow holders of incentive stock options to exercise them and start the holding period for long-term capital gains treatment without fear of being hit with a large AMT bill,” Antonelli says.
Repealing Obamacare’s 3.8% net investment income tax, as both plans intend, would ease planning for many clients. For those in real estate, a common strategy for avoiding this tax is to try to qualify as a real estate professional. But in audits, the IRS often challenges taxpayers’ documentation of their time spent in real estate-related activities, according to Moss Adams’ Stirbis. “Therefore, to avoid having to defend it, some clients choose not to be treated as a real estate professional.” Instead, they suffer the surtax. If the tax were killed, that would extinguish this planning conundrum, Stirbis says.
Deductions are on the chopping block, too. The GOP blueprint jettisons all itemized deductions except mortgage interest and charitable contributions. Trump wants to cap itemizations at $200,000 for joint filers and $100,000 for singles. These approaches to deduction reduction are different from what the current law follows. It phases out itemized deductions based on the client’s adjusted gross income, starting at $313,800 for joint filers in 2017 and $261,500 for single clients.
Tax Bracket Opportunities And Anomalies
Clients with the highest incomes would benefit under both sets of proposals. For example, the top ordinary bracket’s slide of more than 6 percentage points, from the current 39.6% to 33%, would make Roth conversions less costly. So more clients might convert those accounts, Stirbis says.
Although it hasn’t received much publicity, the GOP blueprint proposes to tax interest income preferentially, the way long-term gains and dividends are.
Meanwhile, under the new president’s proposed structure, a few clients would actually pay higher rates. “That’s the sneaky part of Trump’s plan. Taxpayers jump up to the maximum rates more quickly than in the current system,” says Blake E. Christian, a CPA and tax partner at HCVT LLP, in Park City, Utah.
In particular, single individuals with taxable income between $112,500 and approximately $190,000 face a 28% marginal tax rate today, but would land in Trump’s top bracket, 33%. A wider range of successful singles—those with six-figure incomes as high as about $418,000—as well as joint filers with taxable incomes between $225,000 and about $470,000, would graduate to the 20% cap-gains bracket, up from 15% currently. The 5% increase would cost them more than the repeal of the 3.8% surtax would save.
“Changes in clients’ tax rates and on different types of income would impact the relative attractiveness, or unattractiveness, of investments such as municipal bonds and real estate. Advisors will need to take a careful look at clients’ holdings” if these proposals are enacted, Christian says.
Ideas For Business Owners
Sweeping business-tax reform stars in both sets of proposals. The more codified of the two, the House GOP plan, distinguishes between “active business income,” to be taxed at no more than 25%, and “reasonable compensation to owner-operators.” The compensation would be a deduction for the business and ordinary income to the owners, taxable up to 33%.
Trump has famously proposed a 15% tax on income from all manner of enterprise, be it a regular corporation, pass-through entity (S corp, partnership or limited liability company) or sole proprietorship. But this fetching rate is only for businesses “that want to retain the profits within the business,” his thin plan states.
“It could be that part of his proposal is for pass-through entities and sole proprietorships to distinguish between what is compensation to the owner and what is business income to the owner,” akin to the approach in the GOP blueprint, opines Luscombe, the Wolters Kluwer analyst. In that case, Luscombe thinks Trump would let businesses deduct the owner’s compensation, which would be ordinary income to the owner taxed as high as 33%, with the remaining business income taxed at 15%. If distributed, the business’s profits would presumably be taxed as qualified dividends, i.e., as much as 20%.
“There is no means by which a business could get a single layer of taxation at a rate of 15%,” the brainiacs at the Tax Foundation think tank conclude about Trump’s indefinite proposal, acknowledging that others may “perceive things differently.” Given the lack of clarity, the details of any actual legislation will have to dictate whether, as some observers have suggested, Trump’s plan would make workers prefer to be independent contractors (read: sole proprietors) as opposed to employees.
Both Trump and House Republicans want immediate expensing of equipment purchases, rather than forcing deprecation over time, although the new president has placed a cost on this choice. Businesses would lose their ability to deduct interest if they elect immediate write-offs.
The GOP blueprint just says no to deducting business interest. It could only be used to offset the business’s interest income.
Other noteworthy proposals in the House plan include ending carrybacks of net operating losses to prior years—no more amending old returns to get tax refunds—but allowing net operating losses to carry forward without time limit, with an inflation factor to boot. House Republicans also propose preserving the last-in-first-out (LIFO) inventory method, which gives businesses a larger deduction for the cost of merchandise sold in periods of rising prices.
A Sea Change For Estate Planning
Both Trump and the GOP envision ending the federal estate tax, and that’s weighing on a lot of estate planners’ minds right now, confesses Steve Oshins, an attorney and partner at Oshins & Associates LLC in Las Vegas. “But advisors should take a deep breath and remember that even a so-called permanent change only means the change has no official ending date. The next Congress might bring back the estate tax with a smaller exemption and higher tax rate,” Oshins says.
Repeal of the estate tax would require clients’ plans to account for the levy’s possible resurrection. “It is so important to build flexibility into trusts and to plan for the long term,” Oshins stresses.
If the estate tax gets quashed, clients could overreact and get antsy to terminate trusts. “That’s the worst thing they can do. You can’t ‘un-terminate’ a trust if the estate tax is reinstated,” Oshins says. “When making a decision to either do or not do something, always ask what the ramifications will be if the laws change in the future.”
How would estate planners spend their day in a world without federal estate tax? “We would still be using irrevocable trusts for creditor and divorce protection, and to shift income to lower-bracket family members” as well as for other reasons,” says Oshins.
Additional areas of focus would be ensuring the orderly disposition of clients’ assets, advising about family-business succession, and ensuring professional management of assets for family members who are unable to manage them competently, according to Howard Zaritsky, an attorney and expert on estate, gift and GST taxes in Rapidan, Va.
Whether clients would seek out that professional advice is another matter, he worries. “Without the estate tax, many wealthy people would not feel an urgent need for estate planning. The tax is what usually makes them come in for planning,” Zaritsky says.
But at least some individuals with estates measured in eight figures wouldn’t get off scot-free under Trump’s plan. It says, “Capital gains held until death and valued over $10 million will be subject to tax.” Experts differ on what that means, but Zaritsky’s interpretation is that the portion of asset appreciation above $10 million would be taxed as a capital gain. “That would prompt some planning,” he says.
Whether the gift tax would ride into oblivion with the estate tax is another uncertainty. Both Trump and the House GOP have been silent about taxing lifetime transfers.
“If the gift tax were retained,” says Zaritsky, “we would urge wealthy clients to sell assets that are likely to appreciate to irrevocable long-term trusts. A sale would avoid the gift tax, and any future appreciation would be out of the client’s taxable estate, in case the estate tax came back.”
If the gift tax perishes with the estate tax, Oshins says, “then we would have huge opportunities to transfer assets back and forth between high- and low-bracket family members.” Clients could transfer assets to low-income family members to get the assets’ earnings subjected to a low income tax rate. Then the asset could be returned to the original family member to regain ownership, Oshins explains.
Yes, the possibilities are exciting. But a change as seismic as estate tax repeal could have deep repercussions. “Fewer young attorneys would learn advanced estate tax planning,” Oshins observes, “and that would have a negative effect on the industry’s ability to serve clients in the future if and when the estate tax is reinstated.”
But no matter what lies ahead, he says, “The bottom line is that advanced estate planners”—and this is true of all planners—“are trained to find ways to work around changes. We just need to be smart about it.”