Jonathan Dance.musings

Tax March Reform

2017-04-25

On April 15, 2017, I did two things: I paid my taxes, and I participated in my first political march. While the Tax March did not represent my most urgent asks of our Government, it was only the second time I actively participated in government beyond the ballot box. (The first was a letter to the White House about the Internet Privacy Rule repeal.)

Both the act of filing my taxes and the Tax March revolved around a interest of mine: for a layman, I have a strong understanding of The Code. I am frequently consulted by friends and family on the ins-and-outs of how best to handle their returns, and while I frequently refer them to my CPA, I frequently offer advice. After running my own business, and a deep desire to understand as much of my own financial affairs as possible, I have accumulated a thorough knowledge of The Code, often reading IRS publications and, at times, going as far as to read the raw Code itself (like 26 USC § 423).

Undoubtably, The Code is extremely complex. Tax reform is strongly needed. While a more drastic overhaul is needed, in the short term, I believe it is mostly to be in the following areas.

The Alternative Minimum Tax (AMT)

Originally designed to target a tiny number of very wealthy Americans that were maximizing their deductions and “dodging” paying income tax, the AMT now hits millions of Americans (including yours truly). Those of us living in high-tax states (like California and New York) are most likely to be hit, as we cannot deduct state income taxes or property taxes from the AMT, like you can if you itemize your deductions (on Schedule A). If you pay a large amount of state and local taxes, you are more likely to need to pay additional taxes under the AMT in order to hit the “minimum” federal tax.

The result is a feeling of double taxation - in addition to paying high state and local taxes, the AMT adds a federal penalty for doing so.

Additionally, the AMT adds significant hurdles to financial planning. In addition to understanding the impact of the “standard” Code, one must also understand the effects of the AMT. One overly complex Code is bad enough; we don’t need two.

Possible solutions

Political analysis

The AMT hits hardest in liberal states—but also targets wealthy Americans. Republicans are likely to love a full repeal of AMT if they can get it. The returns we’ve seen of Donald’s has shown he has owed lots of AMT in the past, and so he would easily support a repeal of AMT.

Long-Term Capital Gains Tax Incentive

The Long-Term Capital Gains Tax Incentive was passed by Clinton (reduced from 28% to 20%), and then increased further by George W Bush (to 15%). It should be next on the chopping block. This incentivizes people to hold stocks for at least 1 year. If you do so, you need pay (at most) 15% on these capital gains.

Its exact purpose is unclear. It incentivizes long-term investment in the capital markets, but this is not something that should need to be incentivized: the possible growth of the funds should be incentive enough. As such, it is, by and large, a tax cut for the very wealthy, who have the funds to make large, long-term investments.

It also leads to a number of practices that make our lives significantly more complex. First, people often do not act in their best interest, because they hold equities for longer than they should. This can lead to financial ruin. It also means that “tax loss harvesting” (a complex and strange practice in itself) can become further complicated by needed to plan for the tax implications of resetting the 1 year clock. Lastly, the added work of tracking and documenting long-term vs short-term gains are considerable.

Possible solutions

Political analysis

Discounting all capital gains equally at a higher fixed rate may be possible, since investors may like the idea of getting a tax cut on their short-term gains. However, Donald is unlikely to approve of any increase in the long-term rate, since so much of his holdings are in long-term real-estate holdings (which I believe are considered “long-term” gains).

Corporate Tax

Donald would love to see a cut of the Corporate Tax rate on profits from 35% to 15%. Of course, this is likely to benefit Donald, though it only applies to “C” corporations—basically, those corporations that have stock.

This tax is often misunderstood. Corporations pay this tax only on profits. However, profit can only exist in a bank account. It is always eventually spent: it can be spent on future expenditures (which can then be deducted, for a potential tax refund), paid out to shareholders as dividends (who are taxed on those dividends), paid to workers as wages (who are taxes on those wages), or invested (and any gains on those investments are then, again, profit).

The Corporate Tax is, thus, largely a form of double taxation. While some taxation on profit may be reasonable, a 35% tax is uncompetitive in the world. This leads to setting up corporate headquarters overseas, and keeping profits in foreign corporations for as long as possible.

The Corporate Tax accounts for 10.6% of the receipts to the federal government, so its role should not be ignored; however, its overall impact is less than individual income taxes (46.2%). (Percentages are for FY14.)

Proposed solution

The proposed 15-20% tax rate is, theoretically, a good idea. However, this should be balanced against other parts of the Code.

The lower tax rate on qualified dividends (dividends from stock held more than 60~90 days) should be limited, e.g., to $50k/year. This incentive helps seniors who are collecting dividends from bonds and high-dividend equities. However, it is a huge boon to large shareholders who collect millions in dividends. The AMT corrects this, but closing this loophole would be another way to eliminate the need for the AMT.

Political analysis

The Corporate Tax rate cut is likely, though I doubt we’ll see a corresponding correction to qualified dividends. Republicans are likely to count on projected growth and corporations “bringing profits home” to boost the Corporate Tax rolls, though this effect will only be temporary.

It is unclear what tax elections Donald is using for his corporations; he is most likely using “S corporation” elections to avoid the Corporate Tax. Donald may wish to see this reduction so that he can convert to a C Corporation without a tax disadvantage. This would allow him to more bring in outside investors (as shareholders) to his businesses.

Additional Medicare Tax (AMT2) and Net Investment Income Tax (NIIT)

These Obama-era taxes, designed to fund the American Care Act (ObamaCare), are likely on the chopping block. They add additional complexities to the Code which are best handled as a change to the underlying tax brackets, rather than a special tax. Donald and the Republicans are likely to love this tax cut, since it rolls back taxes passed by Democrats, and while it wouldn’t legally defund ACA, it would move funding the ACA into deficit spending.

Lastly: Donald’s Returns

Only by Donald publishing his returns can we move forward with bipartisan tax return. Otherwise, we can not understand how Donald would benefit from these cuts. While any tax cut is likely to benefit Donald, the American people should understand if and how he is going to benefit.

</