Last month, the Obama Administration released its Fiscal Year 2017 Budget, including its Revenue Proposals, known as the “Greenbook.”
“Lame duck President,” you might say, “and Republican Congress. Who cares?”
Well, as the field of candidates has narrowed, tax practitioners have started to review the remaining candidates’ positions on various tax matters. Many observers believe that the Greenbook probably gives us a glimpse of what we can expect to see in the way of tax proposals if the Democrats win in November, and as the late Sy Syms may have said, “an educated voter is our best voter.”
Although closely-held businesses owners will likely welcome many of the proposals put forth by the Administration, there are many others that may give them significant pause.
If Obama Had His Druthers
What follows is a brief description of some of these proposals.
Expensing for Investments Made by Small Businesses. The proposal would increase the maximum expensing limitation to $1 million and the phase-out threshold would remain at $2 million with both amounts being indexed for inflation.
Increase the Limitations for Deductible New Business Expenditures. Currently, a taxpayer is generally allowed to deduct up to $5,000 of start-up expenditures in the taxable year in which an active trade or business begins, and may deduct up to $5,000 of organizational expenditures in the taxable year in which a corporation or partnership begins business. In each case, the $5,000 amount is reduced (but not below zero), by the amount by which such expenditures exceed $50,000. The proposal would consolidate these provisions, and would allow $20,000 of combined new business expenditures to be expensed. That immediately expensed amount would be reduced by the amount by which the combined new business expenditures exceed $120,000.
Like Kind Exchanges. The proposal would limit the amount of capital gain deferred under section 1031 to $1 million (indexed for inflation) per taxpayer per taxable year.
Corporate Dividends. The proposal would amend the Code to ensure that a transfer of property by a corporation to its shareholder better reflects the corporation’s dividend-paying capacity.
It recognizes the fact that corporations have devised many ways to avoid dividend treatment under current law. For example, corporations enter into transactions (so-called “leveraged distributions”) to avoid dividend treatment upon a distribution by having a corporation with earnings and profits provide funds (for example, through a loan) to a related corporation with no or little earnings and profits, but in which the distributee shareholder has high stock basis. Under current law, these types of transactions reduce earnings and profits for the year in which a distribution is made without a commensurate reduction in a corporation’s dividend paying capacity.
Research Incentives. Current law provides a research and experimentation (R&E) credit (recently made permanent), computable using one of two allowable methods. Under the “traditional” method, the credit is 20 percent of qualified research expenses above a base amount. Under the alternative simplified research credit (ASC), the credit is 14 percent of qualified research expenses in excess of a base amount reflecting its research spending over the prior three years. The proposal would repeal the “traditional” method. In addition, the proposal would increase the rate of the ASC to 18 percent. It would also allow the credit to offset Alternative Minimum Tax liability, and repeal a special rule for pass-thru entities that limited use of the credit.
Tax Carried Interest Profits as Ordinary Income. Current law provides that an item of income or loss of partnership retains its character and flows through to the partners, regardless of whether the partners received their interests in the partnership in exchange for services. Thus, some service partners in investment partnerships are able to pay a 20 percent long-term capital gains tax rate, rather than ordinary income tax rates on income items from the partnership. The proposal would tax as ordinary income a partner’s share of income on an “investment service partnership interest” (ISPI) regardless of the character of the income at the partnership level. In addition, the partner would be required to pay self-employment taxes on such income, and the gain recognized on the sale of an ISPI that is not attributable to invested capital (including goodwill) would generally be taxed as ordinary income, not as capital gain. (Secretary Clinton has also proposed to tax carried interest as ordinary income.)
Limit Certain Tax Expenditures for the Most Affluent. This proposal would limit the tax rate at which upper-income taxpayers can use itemized deductions, and other tax preferences to reduce tax liability, to a maximum of 28 percent. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the top three individual income tax rate brackets of 33, 35, and 39.6 percent. (This is part of Secretary Clinton’s tax plan, as well.)
“Reform” the Taxation of Capital Income. This proposal would eliminate the capital gain step-up in basis at death, but with protections for the middle class, surviving spouses, and small businesses. Among other provisions, there would be a $100,000 per-person exclusion of other gains recognized at death. The proposal would also raise the top tax rate on capital gains and qualified dividends from 20 percent to 24.2 percent, or 28 percent including the net investment income tax. (By comparison, Secretary Clinton has mentioned a new rate schedule for capital gains – with rates declining for longer holding periods – and a new holding period (2 years) for long term capital gain treatment. For example, the current 20 percent rate – 23.8 percent including the net investment income tax – would only apply to assets held at least six years.)
Net Investment Income and Self-Employment (SECA) Taxes. The proposal would close perceived “loopholes” in the SECA tax and the Net Investment Income Tax (NIIT). Under the proposal, all active business income would be subject to either the NIIT or Medicare payroll tax, so choice of business entity would not be a strategy for avoiding these taxes. The proposal would also make individual owners or professional service businesses taxed as S corporations or partnerships subject to SECA taxes in the same manner and to the same degree. Thus, for example, the fact that an S corporation shareholder or a partner did materially participate in the corporate or partnership business would not shield their share of business income from the NIIT.
Implement the Buffett Rule: A “Fair Share Tax”. This budget proposal is aimed at ensuring that high-income taxpayers cannot use deductions and preferential tax rates on capital gains and dividends to pay a lower effective rate of tax than many middle-class families. The tax is intended to ensure that very high income families pay tax equivalent to no less than 30 percent of their income, adjusted for charitable donations. (Similarly, Secretary Clinton would impose a minimum 30 percent tax on taxpayers with over $1 million of adjusted gross income.)
Eliminate Technical Partnership Terminations. If within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in a partnership’s capital and profits, the partnership is treated as having terminated for income tax purposes. Even though the business of the partnership continues in the same legal form, several consequences occur as a result of this technical termination that serve as a trap for the unwary, including, among other things, the restart of depreciation lives, the close of the partnership’s taxable year, and the loss of all partnership level elections. The proposal would repeal this rule.
Goodwill Anti-Churning Rules. The proposal would repeal the anti-churning rules applicable to the amortization of certain intangibles (such as goodwill and going concern value).
Restore the Estate, Gift, and Generation-Skipping Transfer (GST) Tax Parameters in Effect in 2009. This proposal would make permanent the estate, GST, and gift tax parameters as they applied during 2009. The top tax rate would be increased to 45 percent and the exclusion amount would be reduced to $3.5 million per person for estate and GST taxes, and to $1 million for gift taxes. (Same for Clinton.)
Modify Transfer Tax Rules for Grantor Retained Annuity Trusts and other Grantor Trusts. Donors use certain types of trusts to minimize taxes. The proposal would require that donors leave assets in grantor retained annuity trusts (GRATs) for a fairly long period of time, prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust, and impose other restrictions. (Same for Clinton.)
Duration of GST Tax Exemption. The proposal would provide that, on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate, thereby rendering no part of the trust exempt from GST tax.
Crummey Powers. The proposal would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion. Instead, the proposal would define a new category of transfers (without regard to the existence of any withdrawal or put rights), and would impose an annual limit of $50,000 (indexed for inflation) per donor on the donor’s transfers of property within this new category that will qualify for the gift tax annual exclusion.
Of course, no one knows.
The foregoing summary covered just a small portion of the 2017 Greenbook’s tax proposals (which also include, among other things, a significant number of changes to the tax treatment of U.S. multinationals).
Some of the proposals are more firmly grounded in politics than in good tax policy. Other proposals represent good policy, though I must confess that the adage of “where you stand depends upon where you sit” is especially applicable to one’s perspective on tax policy.
Regardless of where one stands or sits, it is important that we do one or the other if we hope to have any impact on where the tax laws end up and on how they will affect our economy, our businesses, and our families.