Last week, we looked at some of the tax code changes that could be in store for individual taxpayers. Today, we’ll examine the Trump Administration’s proposals to reform the business tax structure.
The headline-grabbing news was a proposedreduction of the corporate tax rate to 15 percent. Many economists have argued that the existing 35 percent corporate tax rate was harming the global competitiveness of American businesses. (E.g., Young Lee & Roger H. Gordon, Tax Structure and Economic Growth, 89 J. Pub. Econ. 1027 (2005)). Indeed, the nonpartisan Tax Foundation reported that the U.S. had the world’s third highest marginal corporate tax rate in 2016, a finding echoed by global accounting firm KPMG. Such a large rate decrease will surely drive up the CBO score of the tax legislation, but it will be welcome news for businesses and their shareholders should it pass Congress.
Complementing the lower corporate tax rate was the proposal to adopt a “territorial” tax system. Under the tax code’s current “worldwide” system, all income earned by a U.S. company throughout the world is subject to U.S. taxation (although tax is generally deferred until the income is repatriated to the United States, and the company can claim a credit for foreign tax paid on the income). But under a “territorial” system, only income earned in a country is taxed by that country. Similar to the corporate tax rate, many academics believe a worldwide tax system reduces the competitiveness of U.S. companies abroad. Only six other OECD countries employ a worldwide tax system, and most have substantially lower corporate tax rates than the U.S.
Beyond reducing taxable income and (arguably) increasing global competitiveness of U.S. businesses, abandoning a worldwide tax system should also substantially simplify tax planning and reporting for companies with foreign subsidiaries or divisions. For example, the complex “Subpart F” governing “controlled foreign corporations” (see I.R.C. § 951 et seq.) and rules concerning “passive foreign investment companies” (see I.R.C. § 1297), which trigger U.S. taxation of certain foreign earnings, would be irrelevant in a territorial tax system.
The White House also announced a one-time tax on overseas income that has not been repatriated (or taxed). Precisely how such a tax would be implemented is still unclear — it would likely be limited to income already earned, but it’s possible the tax could be incorporated into the aforementioned “territorial” system and apply to all future foreign income as well (which would have the effect of maintaining a worldwide system, with a “preferential rate” for overseas income). There has yet to be any official indication of the tax rate that would apply to income held abroad, though as a candidate, President Trump did discuss a 10 percent “deemed repatriation” tax.
For small businesses, a special 15 percent rate on “pass-through” businesses was the most dramatic change announced. Under current law, “pass-through” entities (partnerships, S Corporations, and LLCs taxed as partnerships or S Corporations) don’t pay income tax themselves. Instead, income earned by these businesses “passes through” to the owners, who report their share of the entity’s income on their individual income tax return and pay tax on it at their ordinary income rates. Many closely-held businesses, even highly profitable ones, choose pass-through entities because they offer a lower net tax rate than traditional C Corporations. (A C Corporation pays a 35 percent entity-level tax and owners pay 15 percent on company distributions, for a net effective tax rate of 44.75 percent. Even for an owner in the highest marginal tax bracket, pass-through income would only be taxed at 39.6 percent.)
Although details of the proposed preferential pass-through rate are still limited, it appears likely that the 15 percent rate will be applied to partnership or S-Corporation income reported on individual tax returns, similar to the manner in which dividend and capital gain income is taxed at preferential rates. The rationale for this sweeping change is presumably to avoid leaving pass-through owners paying a higher tax rate (up to 39.6 percent) than they would under the proposed corporate rate reduction (15 percent each on corporate income and distributions, or 27.75 percent net). And while such a change would represent a substantial windfall for current pass-through owners, Congress and the I.R.S. will almost certainly aim to prevent taxpayers from attempting to transform ordinary income into business income.
The documentation released by the White House also referenced eliminating “tax breaks for special interests,” but did not specify which tax preferences or which industries would be targeted.
Also notable was a change not mentioned by the Administration: a border-adjustment tax or destination-based cash-flow tax. This was featured in the House Republicans’ own tax reform proposal, and many observers believed such a mechanism represented a way (or even the only way) to bridge the President’s protectionist impulses with Congress’s more traditionally-conservative view of free markets.
The White House announced its tax reform plan shortly after its health care overhaul bill appeared to fail in the House. But since then, the health care bill was resurrected (and passed last week), which shifted Congress and the public’s attention away from tax reform. In the meantime, the Administration has also suggested it would soon begin to pursue a significant infrastructure bill. It’s difficult to predict when Congress will take up tax reform, much less the degree to which they will feel bound to follow the President’s lead on the issue. But until then, the proposals discussed here and last week are among the only clues we have to tax code changes that could be enacted in 2017.