Additionally, owners of pass-through entities (sole proprietorships, partnerships and S corporations) might be able to choose a flat rate on their pass-through income rather than the individual income tax rate, which, again, under Trump’s plan tops out at 33%.
Under current law, S corporations and partnerships do not pay entity-level tax; instead, the income is allocated to the owners, who pay the corresponding tax at the individual level. In other words, after initially proposing a 15% rate on all business income, Trump’s advisors backpedaled and stopped providing clarity. For clients who own businesses, the ultimate rate enacted by Congress will have a major effect on after-tax income.
Closing A Loophole Doesn’t Mean Higher Taxes
The president-elect’s plan also closes the “carried interest loophole,” something Trump talked up during his campaign. Carried interest, which is mostly associated with hedge funds, is the income of certain investments that the law currently treats as preferentially taxed capital gains and taxes at 20%.
In the simplest terms, this income is similar to a bonus. For example, say a hedge fund manager sells a portfolio he’s been managing and makes a profit of $2 billion for his clients. And say his contract stipulates he receive 20% of those profits, or $400 million, on top of any regular fees he’s earned for managing the fund. Under the current law, this carried interest income (really a performance bonus) is taxed at 20%. For most employees, performance bonuses are taxed at anywhere from 25% to 39.6% depending on whether they’re grouped with regular income and the size of the bonus.
“Carried interest is treated as a capital gain for them, as if they sold a capital asset, even if they have no money at risk,” says Richard Rampell, a CPA and principal at MBAF in Palm Beach, Fla. “Trump says it should be treated as if you got a bonus working for a company, which is more the reality. My sense is that it’s perfectly reasonable that this income should be taxed as regular income.”
And the handful of hedge fund clients he works with feel the same, Rampell says. “I think they have a sense of fairness about it.”
That said, the reality is that those who earn this type of income wouldn’t see their taxes on carried interest go up under Trump’s plan, because carried interest would qualify for the special 15% business tax rate, meaning the tax on this income would actually go down.
Deduction Changes Hit Low-Income Families
Meanwhile, Trump’s plan would limit deductions. Currently, all taxpayers can claim either certain itemized deductions, such as real estate taxes, charitable contributions and mortgage interest, or a standard deduction of $12,600 (if they are married, half that if single). In addition, each taxpayer may claim a $4,050 personal exemption for themselves, their spouse and any dependents.
Trump’s proposal caps itemized deductions at $200,000 for couples filing jointly and $100,000 for single filers, and it increases the standard deduction from $12,600 to $30,000 for married couples and $15,000 for single people. It also eliminates personal exemptions, as well as the “head of household” filing status, which “would cause many large families and single parents to face tax increases,” according to the TPC’s analysis.
“Under the head of household filing status, if you’re a single parent, you pay taxes at a lower rate than if you were a single person,” Rampell says. “So getting rid of that hurts single people with children, which is kind of a weird thing to pick on.”
These exemption and filing status changes come in addition to an increase in the bottom tax bracket to 12% from 10%. Put all of this together and the result is 7.8 million low-income large families will experience increased tax bills under the Trump plan, according to a study performed by Lily Batchelder, professor of law and public policy at NYU School of Law.
For example, a family of five that currently claims the standard deduction will actually lose deductions under the Trump plan. Under today’s law, they are entitled to a $12,600 standard deduction and $20,250 of personal exemptions, for a total tax benefit of $32,850. The Trump plan replaces that with a $30,000 standard deduction and no personal exemptions.
The Great Unknowns
What remains unclear is when the new tax law will kick in. Historically, presidential tax plans have taken effect on one of the following dates: January 1 of the year it’s passed (in this case 2017); the date of passage; or January 1 of the following year (2018).
“So I would probably advise clients to continue to defer income since rates [under Trump’s plan] will go down,” says Carolyn Mazzenga, the partner-in-charge at accounting and advisory firm Marcum in its Melville, N.Y., office. “I might also recommend accelerating deductions such as contributions, interest and taxes, since the Trump proposal includes a limitation of itemized deductions. A tax projection should be done, though, before you implement.”
The bigger and more important question is how does he plan to pay for such large tax cuts? On this Trump has provided few details. However, one thing is certain. When there are fewer tax dollars coming in, Congress has only two choices: It can cut spending or it can borrow money.
According to the TPC’s analysis of Trump’s plan as it stands, federal revenues would fall by $6.2 trillion over the first decade, before taking into account added interest costs and macroeconomic effects. Including those factors, the federal debt would rise by at least $7 trillion over the first decade and by at least $20.7 trillion by 2036.
Again, Congress likely will reduce or delay some of the cuts to soften their effect. Exactly how they will balance any changes to the plan with spending reductions and debt management will be the $7 trillion question.