As we go into 2017 there are two broad tax reform packages on the table, one from President Trump, and one from House Republicans. For a very good summary of both proposals, see my friend John R. Dundon’s blog post . Rather than regurgitate John’s analysis I want to focus on how these proposals can affect investors if implemented.
Trump’s proposal for personal income taxes is to reduce the top personal income tax rate to 33% from the current rate of 39.6% for married couples earnings over $225,000 and single filers making over $112,500. While this sounds good on the surface, the reduction in rates is primarily financed by eliminating or reducing some deductions (don’t worry, mortgage interest is still deductible).
Trump also proposes lowering the top corporate rate from 35% to 15%, and taxes would only be levied on retained earnings, not distributed earnings. Currently all earnings are subject to the corporate tax. Why does this matter? Currently if a corporation pays a dividend the dividend is being paid out of earnings that were taxed. The company essentially gets no ‘deduction’ for the dividend. This results in double taxation of corporate earnings, first to the corporation and second to the investor receiving the dividend. Trump’s proposal eliminates double taxation of dividends making it more probable that corporations will be more inclined to pay dividends rather than retaining earnings to organically grow the company. For an individual investor, this means that dividends could again provide a larger share of total return on stock investments and make ‘value’ or dividend-paying stocks more attractive.
On the other side of this, many types of publicly traded companies do not currently pay taxes on distributed earnings. These entities include Oil and Gas Master Limited Partnerships, Real Estate Investment Trusts, and Business Development Companies. Provided these types of companies distribute 90% of earnings, they don’t pay tax on earnings – it is taxed on the shareholder (investor) level. The earnings from these companies are not taxed as Qualified Dividends but taxed like interest earnings (Ordinary Income Taxes). Based on the pass-through proposal, outlined in the next paragraph, it would appear these earnings will now be taxed at the top 15% rate, putting them on par with all other dividend paying companies. For an investor, on balance, these companies now become more desirable investments than similarly yielding taxable bonds with the same risk.
The 15% corporate tax rate also applies to income from S Corporations and other pass-through entities such as partnerships. Currently an investor in an S Corporation pays taxes on all earnings from the entity at individual income tax rates. Because individual income tax rates, as proposed, will be more than double the corporate rate this could lead to more small business formation, which I assume is the goal.
This could also lead to some ‘tax gaming’. For instance, consider a highly paid corporate accountant earnings $300,000 per year as a w-2 employee. He would be much better off to form his own S-Corp consulting firm, have the corporation pay the S-Corp then he could pass the earnings through to himself at a 15% rate rather than the top w-2 rate of 33%.
We will continue to monitor these proposals as they move through the legislative process. While we do not give direct tax advice, we do keep abreast of tax changes and will keep you updated. If you are nearing retirement and want an overview of what your tax situation will look like in retirement, based on current tax law, schedule a discovery session with one of our advisors.