Speculating About Tax Reform

04/07/17

I saw the hashtag #UStaxreform trending on LinkedIn and figured now is as good a time as any to add to the conversation about where the future of the U.S. tax system might be headed. Many have already weighed in on the subject, with my favorite perspective coming from the brilliant Tony Nitti of Withum Smith & Brown. This article is meant only as a thought-provoking conversation starter; the last claim I'd ever make is that I have any extraordinary predictive ability. Don't be surprised if my forecast ends up a long way off the mark, but perhaps the background information will prove helpful when you think about the possibilities on your own or discuss them with clients. As always, I will refrain from making any value judgments or endorsing/criticizing any particular politician or candidate.

Realities to Keep In Mind

  • The Republican Party is the majority party in both the House of Representatives and the Senate. However, the Republican Party majority is 52-46 (with two independents who caucus with the Democrats), which is significant because the Republican Senators cannot break a filibuster with a cloture vote by themselves. Instead, the Republican Senators would need 8 Senators from the Democratic caucus for a cloture vote of 60.
  • The Republican Party may make changes without securing 60 votes in the Senate by using the Congressional reconciliation process, a complicated route subject to several restrictive rules. The most famous of these rules is the Byrd Rule, named after Senator Robert Byrd, which requires (among other things) that any change proposed in the reconciliation process cannot increase the deficit beyond the fiscal years covered by reconciliation (typically the next 10 fiscal years). A cool blog post about reconciliation can be found here. The bottom line about reconciliation is that the process makes tax cuts more difficult because lawmakers would need to find ways to generate revenue offsetting the cuts' impact on the deficit.
  • Based on what the Republicans have said, including the President himself, they will seek to implement tax policies that stimulate economic activity. The ones already in place that have a positive impact on the economy will probably be sacred cows. If tax reform does not end up stimulating the economy, the President's legacy may go the way of George W. Bush, whose tax cuts have not been viewed kindly in hindsight.
  • Most proposed tax changes are supported and opposed by various lobbies. These lobbies usually have the power of PACs behind them and can greatly influence legislation, making significant tax reform supremely difficult. What most everyday Americans don't fully understand is that the Internal Revenue Code is so complicated because of how many lobbies have successfully persuaded Congress to make tax changes favorable to their industry, while measures to fix the tax system have been tailored to make sure certain industries are not adversely affected. The only significant tax change that never has substantial opposition is the decreasing of marginal rates, discussed further below. On the flipside, raising marginal rates usually receives opposition from nearly everybody affected.

My Assessment of the Current Political Climate in Washington

The ongoing attempt to repeal and replace the Affordable Care Act has been very revealing about how the Trump Administration and Congressional Republicans will approach legislative initiatives. The White House has emphasized big-picture thinking. President Trump distilled complex matters to brilliant single-sentence or single-phrase tag lines throughout his campaign. Staying true to his businessman roots, he and his staff then delegated the details to Congress. In particular, Speaker of the House Paul Ryan has been saddled with the responsibility of forming a consensus among House Republicans, while Ryan's counterpart in the Senate (Majority Leader Mitch McConnell) will handle the other chamber of Congress.

The health care talks revealed significant divisions within the House Republican ranks. On one side of the political spectrum, House moderates proved they will not rally behind any old proposal if they believe their constituents will respond with vitriol during the 2018 midterm elections. Public polling revealed intense dislike for the Republicans' draft ACA replacement bill, the American Health Care Act. Many House moderates responded by pushing the draft bill's provisions to the left before ultimately opposing the bill's final form because it was not far enough to the left for their liking.

On the other side of the political spectrum, the House Freedom Caucus is entrenched in more comfortable electoral positions. This group of about 30 Republican representatives come from almost uniformly safe GOP districts, meaning they have minimal fears about re-election. Therefore, they are hard-liners about far-right principles and refuse to rally behind any old proposal for exactly that reason. When the AHCA draft bill drifted left, the House Freedom Caucus yanked the bill back to the right before the bill died.

While the Senate appears less divided on the surface, several Republican Senators have mirrored the behavior of their counterparts in the House. In particular, Senators Susan Collins, John McCain, and Jeff Flake have occasionally broken rank from the moderate wing, and Senators Lindsey Graham and Rand Paul have attacked mainstream Republican ideas from the hard-right conservative wing. Because the Republican majority in the Senate would be broken by only three defections, crafting legislation in the Senate is an even more delicate affair than the same task would be in the House, where the GOP has a bit more breathing room.

The Trump White House appears to have several factions constantly struggling for the President's ear. One faction is the right-wing populists, exemplified by former Breibart head Steve Bannon. Another faction is the experienced businesspeople, exemplified by the President's son-in-law, Jared Kushner. A third faction is the mainstream Republicans, exemplified by former RNC Chairman Reince Priebus. The existence of so many competing groups makes forecasting the administration's actions more difficult, but if Priebus is to be believed, the President may seek to court Democrats to push through the tax reform effort.

Thoughts About Washington's Likely Approach to Tax Legislation

Overall, I think the divisions in both the White House and in Congress will force the Republicans to collaborate across the aisle with a relatively small group of centrist Democrats to pass a compromise tax bill without nearly as much significant reform as promised.

  • What About Paul Ryan and Rep. Kevin Brady's "A Better Way?" The two Representatives' proposal, issued prior to the Presidential election, contains too many controversial items to succeed. For one, the Border Adjustment Tax (which would disfavor imports and favor exports) received a lukewarm dismissal from the President himself, and it never bodes well when a lobby consisting of the Koch Brothers, Wal-Mart, Target, and Costco is against an idea. Second, if you think changing the system of personal exemptions, personal deductions, and child tax credits will get any traction with legislators from lower-income districts in middle America, you're kidding yourself. Third, any attempt to cap state and local property tax deductions, the mortgage interest deduction, and/or the charitable contribution deduction will generate fury from legislators whose constituents rely heavily upon them -- Republican Representative Peter King is an example of a Congressman who might be out of a job if he votes in favor of those changes.
  • Why Would the White House Compromise? Because President Trump needs a signature win. The special elections occurring for several seats, such as the district in Georgia formerly represented by HHS Secretary Tom Price, might be a bellwether for the electoral climate in the 2018 midterm elections - and the preliminary indications are ominous for the Republicans. The GOP is hoping for the best and planning for the worst - which could be a shift in the balance of power for one or both chambers of Congress by the time January 2019 rolls around. If the President and his party allies haven't notched a victory by then, the Republicans are at serious risk of losing the White House in 2020, which may turn the tables and completely flip the balance of power between the two major parties.
  • Why Would the Democrats Compromise? Because the ones in purple jurisdictions would be able to claim a victory of their own to better secure re-election, and there's no elixir for re-election quite like a tax cut with a side of reaching across the aisle. In my opinion, the contingent of Democratic voters who would penalize a centrist Democrat for supporting a measure ultimately signed into law by Donald Trump is not large enough to prevent any and all Democratic legislators from attempting a compromise. I think that if a savvy mainstream Republican politician like Marco Rubio spearheads the effort, outreach to the other side will produce a viable bill, similar to what we saw with the Gang of Eight proposal on immigration reform. One more thought: Chuck Schumer is a deal-maker by nature. Don't be surprised if he gets involved with a politician like Rubio to strike a back-room accord to jump-start tax legislation.

Let's Get Down to Brass Tacks: What Do You Think Tax Legislation Looks Like?

I think the framework of tax legislation is an across-the-board marginal rate cut that slightly favors everyday Americans, and the revenue will be replaced by a rollback of tax loopholes without lobbies strong enough to save them. Here is my best attempt at painting the specifics:

  • Individual Income Tax: The top three brackets get rolled back between 1.5 and 3%. The rest of the brackets get reduced by as much as 5%, but no more than that. No major changes occur to popular itemized deductions. Considering Mr. Trump's 2005 tax return is now public, any argument to repeal the alternative minimum tax is effectively dead.
  • Corporate Income Tax: Rates get cut by 5-10% across the board. Overseas profits might get a repatriation holiday, but certainly not at a rate as low as 10%. Perhaps this repatriation rate could be set between 15% and 25%. Repatriation would be a significant one-time revenue-raising measure, but it would reinforce the perverse incentive created by the first round of repatriation: corporations could continue keeping profits overseas and wait for the next time the federal government needs money to bring those profits back stateside at a discount.
  • Estate Tax: The estate tax rate may get reduced by 5-10%, but I doubt it gets touched at all. For all Democrats, a cut on a tax that so disproportionately affects the wealthy would be a non-starter. For the Republicans (especially the White House), a cut or complete elimination of the estate tax provides political opponents in 2018 and 2020 with way too much easy fodder in debates. The headlines would also be very easy for the media to write: "Trump signs into law massive tax cut on himself" would be a horrible look, and the word "kleptocracy" would be thrown around quite easily. Estate tax revenue might only account for about 1% of revenue in the budget, but repealing it would not produce any economic activity and may actually result in job losses. Furthermore, if tax reform will be even remotely revenue-neutral, replacing the estate tax revenue will be a major nuisance. While repealing the estate tax has been a Republican talking point since before the new millennium, the party has never been able to accomplish it despite having similar control of the federal government at certain times in the previous decade. My prediction is that the estate tax probably gets left alone.
  • Gift Tax: As many smart practitioners have pointed out, the gift tax backstops the state income tax. Example: I'm a New York resident, and I'm about to sell my business. I gift my entire ownership interest to my son, who is a Florida resident. The gift comes without a tax consequence because the gift tax has been repealed. The ownership interest is sold in my son's name, and no state income tax is due. My son waits until the next taxable year and gifts the proceeds back to me, which also comes with no tax consequence. Voila -- I sell my ownership interest and avoid New York's state income taxes. Because of this enormous potential for abuse, the gift tax is likely here to stay.

What about loopholes? I can think of a few that can easily be closed to raise revenue:

  • Carried/Promoted Interests: In layman's terms, the carried interest is the incentive for fund managers and real estate project managers to maximize return on the investors' capital. The carried interest is entirely dependent on how successful a venture is -- if the venture loses money, the carried interest isn't worth anything. For instance, hedge fund managers typically take a 20% carried interest, meaning that the manager will get 20% of the returns they generate for their clients over and above a certain threshold. The carried interest is designed to align the interests of the people who invest money in an entity and the people who determine how that money will be deployed. There are two sides to the carried interest debate. One side says that since the carried interest comes with entrepreneurial risk, the carried interest should receive long-term capital gain treatment. The other side says that the carried interest looks more like the manager's compensation for its services, which should be taxed as ordinary gain. Right now, carried interest is taxed as long-term capital gain. However, the President stated during the campaign that he is open to taxing carried interests as ordinary gain. Since most politicians' constituents hate Wall Street, any tax increase almost exclusively targeting Wall Street would not meet much political resistance. I believe it would be politically easy to tax carried interests of financial firms as ordinary gain while excluding real estate holding companies. Mechanically, the statute may be tough to draft, but political support would likely be found easily. This measure alone would raise several billion dollars annually for the Treasury.
  • Stretch IRAs: Since I'm not too familiar with the legislative history behind the creation of stretch IRAs, I have no idea how they were ever allowed in the first place. The IRA "stretch" is a feature found in Sections 401 and 408 of the Internal Revenue Code and the corresponding Treasury Regulations. It allows non-spouse beneficiaries of an IRA to take the required minimum distributions (RMDs) over the beneficiary's lifetime rather than the lifetime of the original owner. Contrast this feature with 401(k)s and other retirement plans, which must be emptied within five years of the death of the original owner (or the survivor of the original owner and her spouse). You might not think this feature makes a real difference, but project the numbers for a six-figure Roth IRA and calculate how much the Treasury is missing out -- you'd be floored, and that's before you get to Mitt Romney's nine-figure Roth IRA and others like it. Again, this measure alone would raise several billion dollars annually... and it's already passed the Senate Finance Committee unanimously in prior votes. When else can Republicans and Democrats unanimously agree on anything!?
  • Section 1031 "Program" and Artwork/Collectible Exchanges: Calm down, real estate owners -- I'm not talking about your garden-variety 1031 exchanges, which are a major economic driver and a linchpin of the real estate industry. I'm talking about two other types of 1031 exchanges. The first are artwork and collectible exchanges, in which taxes are being deferred on the sale of investment artwork and other collectibles. I wrote an article about how tough these are to pull off in the first place, but where there's a will, there's a smart tax lawyer -- and even when there isn't a smart tax lawyer, there's an undermanned and underfunded IRS without the sufficient resources to detect taxpayers abusing the system. Most everyone agrees 1031 exchanges were not originally designed for artwork or collectibles, and since this loophole overwhelmingly favors wealthy individuals without a strong lobby, rolling them back would be relatively easy. The second type of exchange is a so-called "program" exchange, in which owners of durable trade or business assets are constantly engaging in a 1031 "program" to turn over these assets tax-free. For instance, the rental car companies never pay taxes on the sale of old rental cars in their fleet -- they use 1031 to just buy new cars to replace the old ones. Construction companies use 1031 for their equipment, too. While an attempt to get rid of "program" exchanges would encounter a stiff lobby, repealing them would be really easy to justify politically because the only benefactors are enormous corporations; meanwhile, leaving real estate exchanges in place would serve as a good compromise for politicians on both sides of the aisle whose constituents depend heavily on 1031 to keep their real estate businesses in good shape. You may not think of this measure as a big revenue raiser, but projections say this is another source of multi-billion dollar annual revenues.
  • The Annual Gift Tax Exclusion: Mikel was the most recent case to add salt to the proverbial wound for the IRS -- time after time, the Tax Court and other federal courts have approved taxpayers taking massive liberties with the federal annual gift tax exclusion. Any savvy estate tax planner finds ways to exploit this loophole for wealthy clients, and I wouldn't be surprised to see lawmakers close it. While Congressional Budget Office projections may not chalk this loophole up as a big revenue raiser, I think nobody should underestimate how much money this loophole allows people to save -- it's not only the annual gifts themselves that avoid estate and gift taxation, but it's also the assets purchased by leveraging these annual gifts (such as life insurance or closely held business interests).
  • Walton GRATs: All estate planners love Walton GRATs, or "zeroed-out" GRATs, as wealth transfer tools. Ever since the IRS passed regulations under Section 2702 of the Internal Revenue Code in the early 1990s, the estate planning community immediately spotted a loophole that the Service itself had created -- an example in the Service's own regulations tied the organization's hands when it tried to argue against the viability of zeroed-out GRATs. The Walton family of Wal-Mart fame used this technique to avoid millions of dollars in transfer taxes, then successfully defended its actions in Tax Court. Later, Sheldon Adelson used the technique to benefit his family handsomely when his company's stock rebounded following the financial crisis. Later still, the Facebook billionaires used pre-IPO GRATs to their advantage, some of which benefited children the founders did not even have yet. If Congress put a minimum term and minimum remainder interest on GRATs, I have no doubt they would raise money despite installment sales to grantor trusts serving as a viable alternative. Perhaps Congress could even pass rules about intra-family installment sales to further ensure that the changes raise maximum revenue.
  • College Endowments: I'm surprised how little attention this gets in the national media, but Senators like Chuck Grassley have raised this issue before. Here's a list of the top colleges and universities in America by endowment. Check out my two alma maters: Washington University in St. Louis boasted a $6.8 billion endowment in 2015, and Georgetown University had its own impressive $1.5 billion endowment. Add the entire list together, and you're left with a sum totaling the better part of a trillion dollars. Every dollar of income generated by that total is exempt from income taxes because the beneficial owner happens to be a higher education institution. I'll add as food for thought that these same institutions ask their students to go into debt to pay tuition that nowadays more closely resembles a mortgage. Did I mention the interest rates are also markedly higher than any other unsecured loan made for a government-sponsored purpose? Given these facts, endowments seem a ripe target for taxation, especially given the sums of money potentially raised when perhaps a trillion dollars of principal experiences recognition events. This measure has never been seriously discussed, but I wouldn't be surprised if a populist legislator uses it as the crux of a clarion call.

I'll also note one other category of potential revenue raisers that are neither marginal rate increases nor loophole closers: administrative changes. For instance, the CBO estimates that the new partnership audit rules taking effect in 2018 will raise several billion dollars of revenue in the coming years. Beefing up the IRS would be a net benefit for the Treasury for the following reasons:

  • Stricter Compliance: A higher rate of audits would make taxpayers think twice about taking aggressive positions on their tax returns. The nationwide ripple effect would likely result in more revenue.
  • Enforcement Against Tax Shelters: I've seen a rash of tax shelters popping up recently, and nipping them in the bud would both discourage new ones and decrease taxpayer participation in the existing ones.
  • Increased Litigation: A better budget for the IRS to take cases to Tax Court would change planners' approach and put a higher expected cost on a challenge to a taxpayer's position.

To sum up, I think the approval of some Democrats would allow Washington to pass a compromise bill that would increase the deficit by a moderate amount relative to the massive tax cut originally proposed by both the President and House Republicans. Perhaps the above serves as a skeletal framework for a viable tax bill.

I hope my contribution to this widespread national discussion proved valuable for you. I'd welcome any questions or other feedback about my opinions on this subject. Only time will tell how much of it proves accurate!


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