TAXATION - U.S. Tax Reform: The Impact on Taxpayers and Corporations

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President Donald Trump has signed into law a bill signifying the largest tax cuts in U.S. history in hope of boosting economic growth. George McCormick, a Hong Kong-based registered foreign lawyer at Withers specializing in U.S. tax, trust, and estate planning, explains what it all means for American individuals and businesses

By Kenny Lau


What are the U.S. tax cuts all about?

Discussions have taken place in Congress for years about reforming the tax code, simplifying it, and reducing tax rates; yet, there had been no dramatic changes in the past several years. The framework released on September 27 was the first significant step to dramatically reform the U.S. tax code. The House of Representatives then passed H.R. 1 (“Tax Cuts and Jobs Act”) on November 16 while the Senate passed its version of tax reform with some similarities but also noticeable differences on December 2. Significantly, both chambers of Congress have now passed this legislation of tax reform, and President Donald Trump has subsequently signed the bill into law.

What are the implications for U.S. taxpayers?

For individuals, one of the goals of tax reform was to simplify the tax code and make filing easier. As an example, in the House’s version of the legislation, the number of income tax brackets would be lowered from 7 to 4 brackets while the amount of income tax deductions would be reduced. Ultimately, the number of tax brackets will remain the same, but the highest rate will be lowered from 39.6 percent to 37 percent. The drive to eliminate tax deductions could have the effect of reducing certain individuals’ tax liability but could also have the result of increasing it for others.

Under the finalized legislation, some deductions were modified or eliminated in the name of simplicity and for revenue raising to pay for rate cuts elsewhere. One example of a modified deduction is the “state and local tax deduction” used by many taxpayers in states such as New York and California to deduct state and local taxes paid on their federal income tax returns. Under the final version of the bill, deductions for state and local taxes will be capped at US$10,000 a year. This will certainly impact high-earners and those who pay high property taxes in those states.

Also, another popular deduction, for mortgage interest paid, will be diminished in effect as well. In the end, it could have been worse, from a taxpayer’s perspective, given that previous iterations of legislation would have eliminated the state and local tax deduction and further minimized the mortgage interest deduction.

To what extent does it affect federal estate tax liability?

Notably, the federal estate tax will be significantly altered. The current US$5 million unified credit against estate and gift tax will be increased to US$10 million per person, although this credit amount will revert to US$5 million after 2025. In the House’s original bill, it would have eliminated the estate tax, but differences with the Senate’s legislation eventually resulted in a compromise that maintains the estate tax for wealthy individuals.

Relatedly, “basis step-up” will be kept – which means that property inherited will continue to receive a cost basis in the hands of the recipient based on the value at the date of inheritance. This provides a substantial income tax benefit for recipients of inherited property as any built-in gain of an asset is essentially wiped away on the owner’s death.

Given the much larger estate tax exemption, it will be interesting to see if states such as New York, which impose their own estate tax, will follow suit and increase their estate tax exemption or maintain it at current levels. This would be highly relevant for residents and purchasers of properties in those states. It is worth noting that many of the changes in the legislation for individuals are subject to a “sunset” clause and will phase out after 2025.

What about the impact at the corporate level?

Corporations and businesses will see dramatic changes as well. First and foremost, the highest rate of U.S. federal corporate income tax will be reduced from 35 percent to 21 percent. Also, U.S. corporations will move to a somewhat territorial-based tax system that would effectively exempt from U.S. tax dividends on earnings from foreign subsidiaries.

For owners of “pass-through” businesses like sole proprietorships, partnerships, and limited liability companies, there will be a new deduction equal to 20 percent of their business income for a given year. As owners of pass-through entities pay tax on income earned annually by their businesses, this could lower the tax rate for a business owner from a rate of 37 percent to below 30 percent.

How will U.S. businesses benefit in terms of offshore earnings?

An important provision in this law provides that U.S. corporations will very generally not be subject to U.S. corporate income tax on future offshore earnings. This will allow them to expand and invest using that income that has not been taxed by the United States (although it may have been taxed by a foreign country). It will not be a completely tax-free ride, though, for U.S. corporations with overseas business activities. For example, the new law will levy a one-off tax on previously earned offshore income. The tax will be applied on income invested in most types of assets, like cash, at a 15.5 percent tax rate, although income that has been invested in illiquid assets would be subject to a tax of 8 percent.

How are U.S. citizens working/living abroad affected?

As U.S. citizens are subject to U.S. federal income tax reporting on a worldwide basis, most of the changes for individual tax reform will affect U.S. citizens living abroad. Although there have been proposals publicly floated to exempt U.S. citizens working and living abroad from annual U.S. tax reporting, those plans were not included in the final legislation.

Citizenship-based taxation is uncompetitive for the plain reason that the United States is one of the few countries in the entire world that taxes on a citizenship basis. It is also the only developed country to do so. Although the U.S. attracts many highly-skilled immigrants, its citizenship-based tax system (and taxing Green Card holders on a worldwide basis) could discourage some immigrants from moving to the United States.

Unfortunately, for American expats, this round of tax reform is complete, and U.S. citizens will continue to be taxed on a worldwide basis while U.S. corporations will move to a new system that will largely exempt their overseas earnings from U.S. taxation.

What are the potential impact on international (non-U.S.) investors?

The reductions in income tax rates are important because Asian corporations and investors are subject to tax on income derived from U.S. sources, including rent and gains from the sale of U.S. property. As of now, gains on property sales are taxed at higher rates for corporations than for individuals and pass-through entities like partnerships.

Going forward, investors in U.S. real estate, whether individuals, corporations or partnerships, will likely see lower rates of tax and greater return on their investment. In fact, the reduction in the U.S. corporate tax rate may make investing in the U.S. through a corporation more appealing, which historically has not been the case. Importantly, Asian individual investors should remember that unlike U.S. taxpayers, non-U.S. taxpayers only have a US$60,000 U.S. estate tax exemption – which means they should take into consideration the U.S. estate tax (and ways of minimizing the tax) when investing in U.S. real estate. However, for international investors, the estate tax exemption for them was not changed in this legislation.

Overall, how does it all compare to President Reagan’s trickle-down economics?

There are similarities in the sense that this reform could lead to higher income earners seeing the most direct benefit. This may be intentional like trickle-down economics and somewhat unintentional in the sense that experts often say that the top one percent of income earners pay a substantial amount of the income taxes collected. For example, for 2014 the Tax Policy Center stated that the top one percent paid nearly 45 percent of the individual income taxes collected. Any reduction in tax rates or alteration of tax brackets may disproportionately benefit this group, whether intended or not. There are certainly differences, though, when this legislation is compared to the results of the Tax Reform Act of 1986. In some respects, it appears to make that effort more progressive than this one. For example, in 1986 there was little change to the estate tax, limitations were created to eliminate tax shelters, and capital gains were taxed the same as ordinary income.