This post was originally published on Forbes Sep 28, 2015
The Donald Trump tax plan is out. Big picture it seems like people who don't pay much now will pay nothing and everybody will pay a lot less, but it is revenue neutral. I'll save the scoring part for the people who do that sort of thing. I'll be very surprised if it turns out to revenue neutral. Here are the high points
1. If you are single and earn less than $25,000, or married and jointly earn less than $50,000, you will not owe any income tax. That removes nearly 75 million households – over 50% – from the income tax rolls. They get a new one page form to send the IRS saying, “I win,” those who would otherwise owe income taxes will save an average of nearly $1,000 each.
2. All other Americans will get a simpler tax code with four brackets – 0%, 10%, 20% and 25% – instead of the current seven. This new tax code eliminates the marriage penalty and the Alternative Minimum Tax (AMT) while providing the lowest tax rate since before World War II.
3. No business of any size, from a Fortune 500 to a mom and pop shop to a freelancer living job to job, will pay more than 15% of their business income in taxes. This lower rate makes corporate inversions unnecessary by making America’s tax rate one of the best in the world.
4. No family will have to pay the death tax. You earned and saved that money for your family, not the government. You paid taxes on it when you earned it.
Picking A Nit
I was pleased that Trump did not lead with the falsehood that the "tax code" is 70,000 pages as several of his competitors, most notably Jeb Bush did. Still there is something that I consider just a bit of a fallacy.
This plan simplifies the tax code by taking nearly 50% of current filers off the income tax rolls entirely and reducing the number of tax brackets from seven to four for everyone else.
In the relative scheme of things, more or fewer brackets does not matter very much when it comes to complexity. More significantly reducing the number of filers does not reduce the code's complexity. Presumably many of them did not have very complicated returns.
The other thing is that many low-income filers are filing in order to get the earned income credit. I just looked at a return whose only income was a W-2 of about $20,000 with one child. The $500 in income tax is nicely taken care of by the child credit and the balance of the child credit and the earned income credit, in effect, create a negative income tax of about $3,000. Does the Trump plan leave the earned income credit in effect? If so, there might not be the dramatic drop in filers claimed. If he is getting rid of the earned income credit, that could be a huge blow to low-income families.
The other thing is that many low-income filers are filing in order to get the earned income credit. I just looked at a return whose only income was a W-2 of about $20,000 with one child. The $500 in income tax is nicely taken care of by the child credit and the balance of the child credit and the earned income credit, in effect, create a negative income tax of about $3,000. Does the Trump plan leave the earned income credit in effect? If so, there might not be the dramatic drop in filers claimed. If he is getting rid of the earned income credit, that could be a huge blow to low-income families.
Life Insurance
I'm not exactly sure what he means by - "The Trump plan also phases out the tax exemption on life insurance interest for high-income earners". The build up in value of a whole life insurance policy is tax-deferred and proceeds payable because of the death of the insured are exempt. Eliminating the exclusion for proceeds paid at death would upset a lot of estate plans, including, for example, mine. Of course someone who funded a life insurance policy in order to provide liquidity for estate tax purpose can feel like a real winner, but that is hardly the only application of life insurance.
I have an off the record comment from someone with quite a bit of expertise in life insurance tax issue.
Life insurance is not the investment of choice for the wealthy. There is no opportunity for capital gains and lower tax rates on dividends. If you cash your policy in, you're taxed at your marginal income tax rate. To get a tax-free benefit, you have to hold it until death. But a tax-free death benefit is no different than the basis step-up that other investments enjoy. So, while inside buildup sounds a great deal, it often pales in comparison to the tax treatment of other investments. Trump's attack on life insurance inside buildup is also probably overkill: He's also proposing a repeal of the estate tax, so there would likely be much less of a need for the wealthy to buy life insurance in the first place. Considering that permanent life insurance is one of the safest investments that people can make, it baffles me why it attracts so much negative attention.
Carried Interest
This one is really peculiar, because when you put all the pieces together I don't think that there is any revenue gain at all from eliminating the "loophole". Carried interest is not really a loophole, rather it is a result of fundamental principles of partnership taxation. Essentially a partner stands in the shoes of the partnership, so if a partnership has a capital gain, it is capital gain to the partner, even if the partner did not contribute any capital. At any rate the way people who run investment partnership are compensated is by an asset-based fee and a share of capital gains. The latter is the "carried interest" that has everybody upset.
Trumps plan calls for a top capital gain rate of 20%. Trump also calls for a maximum 15% rate on business income
No business of any size, from a Fortune 500 to a mom and pop shop to a freelancer living job to job, will pay more than 15% of their business income in taxes.
Presumably he means income tax not "taxes", since proprietors and partners pay self-employment tax of 15.3%. Regardless, this change will turn decades of tax planning on its head. The holy grail of tax planning has been devising schemes to convert ordinary income into capital gains. "Carried interest" was just one of those techniques. Personal goodwill is another example. Under Trump's regime converting business income to capital gain is turning gold into lead. He does not need legislation to eliminate "carried interest", the 15% business rate does it. This reminds me just a bit of the Green Party in 2012 which wanted to eliminate the capital gain preference and carried interest.
Who Will Ever Pay More Than 15%?
Trump's scheme would seem to make it so everyone will want to be an independent contractor and that ordinary business income will be the most favored type of income. Whatever he thinks, the transition to this system will not be simple. Right now the IRS fights with S corporations that pay meagre or no salaries to avoid employment taxes. Now we will add a 10% income tax spread to the mix. What the policy rationale is for taxing an independent contractor at 60% of the maximum rate for an employee is a mystery to me.
The other question to ask is who will want to defer business income with a 401(k) or the like, since the payout might be taxed at a higher rate than the deduction yields in savings.
Strategy
If you think that Trump will win and enact this program normal tax planning is the order of the day. Accelerate deductions and defer income as much as possible. Professional C corporations, which actually have been dinosaurs since 1987, should become entirely extinct. If you are starting a new business definitely go with an LLC and don't think about converting it till after everything has shaken out. If you have high net worth, be sure to hold off from dying until well into 2017.
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