The House Tax Reform Blueprint: What would the building inspector say?
INSIGHT ARTICLE |
This article discusses some of the domestic issues presented in the House GOP Tax Reform Blueprint. For more information about the Blueprint's proposed impact on international taxation, see our article, Border Adjusted Tax proposals may impact exporters and importers.
The Republican leadership of the House of Representatives, and the leadership of the Ways and Means Committee, have advanced an innovative tax reform proposal that is commonly referred to as the Blueprint. As expected of nearly all income tax reform proposals, it would reduce individual income tax rates and the number of tax brackets, paying for those rate reductions with a broadening of the tax base. For example, the Blueprint would reduce the top individual income tax rate from 39.6 percent to 33 percent, eliminate the alternative minimum tax, and eliminate most individual, non-business deductions, other than those for mortgage interest and charitable donations. It does not appear that the existing social security tax on earnings above the “wage base” of approximately $120,000 would be affected. The Blueprint’s most important innovation, however, is its novel approach to the taxation of business and investment income, described more fully below.
How the Blueprint would change the taxation of business and investment income
Instead of putting business and investment income in the same “bucket” as income from personal services, and subjecting it to the same graduated rate schedule from 0 percent to 33 percent, the Blueprint purports to move in the direction of a consumption tax by reducing the top tax rates on business and investment income earned by an individual, below the top tax rates that would apply to the same individual’s income from wages, salaries or other types of personal service income. In particular:
- Capital gains of individuals and qualified dividends would enjoy a 50 percent exclusion, to produce an effect similar to the reduced capital gains rate of current law, resulting in a top tax rate of 16.5 percent for individuals otherwise subject to the 33 percent top rate.
- The same 50 percent exclusion would apply to interest income.
- The operating income of non-corporate businesses (such as partnerships, LLCs, S corporations, and sole proprietorships) would be taxed at a top rate of 25 percent.
- The corporate tax rate would be reduced to 20 percent. However, when added to a maximum 16.5 percent tax imposed on corporate dividends (or capital gains from the sale of corporate shares) the combined maximum individual and corporate tax imposed on corporate earnings distributed to individuals would be 33.2 percent. Thus, an approximate 8 percent rate differential would exist between the tax imposed on business income earned by a C corporation, and the top rate for income earned by a proprietorship, partnership, LLC, or S corporation.
- It is unclear how the existing 3.8 percent tax on net investment income would be affected. Although that tax may be repealed if the Affordable Care Act (ACA) were repealed, the associated revenue may be needed to fund a replacement for the ACA.
In addition to these explicit rate changes, the Blueprint would make what some have called a “radical” change to the rules governing the computation of business or investment income.
- Instead of deducting depreciation more-or-less ratably over the estimated economic life of an asset, the entire cost of a depreciable asset would be immediately deducted, an approach referred to as “expensing.”
- This would not only apply to assets with short and medium-term lives, like vehicles or factory equipment, but also to depreciable real estate, which is today generally treated as having a depreciable life of 30 to 40 years depending on its use.
- At the same time, deductions for net business or investment interest would be disallowed, not only for corporations (as some have proposed in the past, to equalize the treatment of corporate stock and debt) but also for businesses or investment activities operated as partnerships, S corporations, LLCs, or proprietorships.
- Finally, to deal with the problems of asset-owners who do not have sufficient current taxable income to utilize the benefits of up-front expensing of depreciable assets, any resulting net operating losses would not only be carried forward, but would be increased by some sort of “interest” factor to preserve their present value. The goal, in theory, is that the discounted present value of an expensing deduction – say for 100 percent of the cost of an apartment building constructed on leased land, and owned by a single investor with no other sources of income – would be the same as if the apartment building were owned by an individual with large amounts of income from other businesses or investments. For example, a $100 NOL that could not be used in 2020 might “grow” into a $105 NOL in 2021. It is anticipated, however, that current passive activity loss rules would remain. It does not appear that any new limitations would exist on using passive loss carryforwards against unrelated income. It is less than clear if there would be any relaxation on the current rules against corporations using their unused NOLs following a change in ownership.
Possible unintended consequences of these changes
In recent years, industrial enterprises have enjoyed accelerated or bonus depreciation on vehicles, factory equipment and other assets as a temporary stimulus. However, the changes outlined above have been described by some observers as a "radical" change to the way the tax code currently taxes longer lived assets, such as real estate, with potential spill-over effects on the nature and structure of the markets for debt instruments. Among the questions raised by this approach are the following:
For any individual project, would the benefits of expensing exceed the detriments of the loss of interest deductions? Preliminary estimates are that the “break-point” is a project financed with a loan-to-value ratio of under 60 percent.
Could the detriments of lost interest deductions be indirectly ameliorated if the debt were held by individuals, who would benefit from a new 50 percent exclusion of interest income? Would turning the bonds into the equivalent of partially-exempt municipal bonds reduce the interest rates on such instruments, in much the same way that fully-exempt municipal bonds generally bear a lower interest rate than taxable bonds? Or would there be a windfall of lower taxation for individual bond holders, without reduced yields? How would this affect, or be affected by, changes to the tax treatment of other assets?
If there are any changes to the yields on bonds subject to the 50 percent exclusion, how would this affect the market for other tax-favored investments like traditional municipal bonds or certain insurance products?
Could the loss of interest deductions, for real estate investments, be addressed by issuing preferred equity instead of debt? For some tax-exempt investors currently preferring “debt” to avoid the risk of unrelated business income tax (UBIT), preferred equity backed by real estate rents might continue to be exempt from UBIT, if it is not otherwise debt-financed. Thus, if a conventional bank or other real estate lender could be replaced, on the margin, with a pension fund holding preferred equity, the developer would appear to enjoy the full benefits of expensing without any related disallowance of interest deductions. Instead of interest deductions, the holder of the common equity interests would obtain a similar benefit by allocating a share of the income to the holders of the preferred equity.
- By the same token, could preferred equity replace conventional debt because of the advantages for equity holders otherwise subject to UBIT on unrelated debt-financed income?
- Are there non-tax (or tax) reasons why approaches such as these, to minimize the costs of interest deduction disallowance, could not work?
- Would there be movement towards more ownership of real estate, or other assets, by users as opposed to lessors?
- Even if the overall economic impact is a net positive, for the economy and for real estate in particular, would the transition problems of educating would-be investors about the new rules, and seeing major shifts in the portfolio of existing debt and equity holders, cause substantial short-run problems?
- How would transition rules apply to existing assets, and existing debt? Could or would there be a rush to dispose of existing assets, to acquire new, fully expensable assets? Could any resulting decline in values have negative impacts on the availability of financing, potentially creating a vicious circle?
Can other, potentially less disruptive approaches, including further rate reductions, produce the same benefits as expensing?
Some have questioned whether a somewhat different approach could be taken to achieve similar economic results.
For example, in the case of real estate, instead of allowing expensing of 30 and 40-year assets, and disallowing related interest deductions, interest deductions might be preserved, but assets might be only 50 percent expensed, or depreciated over a life that is one-half their current economic life (such as 15 or 20 years instead of roughly 30 or 40 years in the case of real estate). That might have a similar stimulative effect with fewer disruptions to the real estate and capital markets. A similar approach could also be applied to assets generally, although the disruptions caused by the full expensing proposal may be less problematic in the case of non-real estate assets, like trucks or factory equipment.
Alternatively, instead of allowing for faster depreciation (or full expensing) an outright reduction in the applicable tax rates could accomplish a similar effect. For example, taxing a real estate investment at 25 percent with full expensing and disallowance of interest deductions could be the equivalent of using normal depreciation and interest deduction rules but lowering the tax rate, say, to 22 percent. That could achieve similar levels of economic stimulus with fewer transition issues.
Still others have suggested that a simple across-the-board rate reduction for all types of income, similar to that enacted in 1981 under President Reagan, might make more sense and be more easily achieved than a more complicated effort at tax reform.
Reasonable compensation and carried interest
Finally, it should be noted that under any version of a system with a reduced rate for business and investment income, it will be necessary to determine the extent to which purported business or investment income is properly treated as disguised personal services income. To use a very simple example, would a married couple that owns and operates a bed-and-breakfast be permitted to pay tax on all of their net rental income at a 25 percent tax rate, or would a portion need to be treated as a disguised payment for their personal services (i.e., cooking breakfast), taxable at a top rate of 33 percent? The same issue would arise for the full-time CEO of a multi-million dollar manufacturing business who also owns substantial equity in the business.
A similar issue could arise as an aspect of dealing with the treatment of “carried interest.” Opponents of carried interest, correctly or incorrectly, have made the argument that a service-partner who provides services to a partnership, and receives a profits interest disproportionate to his or her capital investment, should arguably treat some portion of the income from the interest as if it were disguised compensation for services (taxable at marginal rates up to 33 percent) even if, in form, it is realized as operating income or capital gains, otherwise taxable under the Blueprint at a rate of 25 percent or 16.5 percent.
 From the Blueprint:Finally, this Blueprint assumes that the substantial tax increases enacted as part of the Obamacare law will be repealed as part of the proposal of the Health Care Task Force. Repeal of economically damaging tax increases such as the additional 3.8 percent tax on net investment income, the additional 0.9 percent payroll tax, the medical device tax, the health insurance tax, and others should not be paid for with other economically damaging tax increases. Rather, they should be paid for by repealing the massive new entitlement program created by Obamacare. Thus, this Blueprint envisions a pro-growth tax code without either those Obamacare taxes or other taxes to replace them.