By Christopher Hynes, JD, CFP
Regardless of your political perspective, tax laws have without doubt changed in significant ways this year and depending upon who wins the election, tax increases may be inevitable. Chris Hynes, SVP of Tax Consulting for Tax Law Solutions provides some useful insight.
Predictably, opinions regarding who finished 1st and who finished 3rd in the initial 2020 presidential debate remain divided (Chris Wallace seems to be the consensus 2nd place finisher…). Prospective voters are similarly split on the sub-issue of Donald Trump’s taxes. Like the larger question of who prevailed in the (over) moderated insulta-thon, the resolution to this issue is clearly a matter of perspective: is it dishonest or unfair for a billionaire to pay less in federal income tax than his secretary (I know, that was a different billionaire)? Or, with due attribution to Bill Belichick, is Trump simply ‘playing the game as the game is played’. Ergo, isn’t any animus directed at the ‘player’ de facto illegitimate?
Irrespective of the answers to the above questions, if Biden is elected our 46th President of the United States in November—and actually inaugurated in January (or perhaps ‘installed’ as the late Justice RBG foreshadowed)—would his currently proposed tax plan close the perceived “loopholes” that seemingly enabled his predecessor to only pay $750 to Uncle Sam in 2017 (more details on this assertion below…)? Of course, this might be a purely academic exercise given that, if the Senate stays red (or somehow the House flips to the Republicans), President Biden would presumably be ‘checked’ and unable to implement much—if not all—of his tax plan.
The Biden Plan and Its Target Income
For non-billionaires, because there is a very real chance that the outcome of many of these races might not be known in tax (calendar) year 2020 due to 80 million mail-in ballots and other potential shenanigans already reportedly afoot, it is important to war game out how much of our money we’ll get to keep under various scenarios. If the executive branch and both chambers turn dead red in January 2021, will you be better off than under the current fiscal environment and the recent changes imposed by the Trump administration’s Tax Cuts and Jobs Act (TCJA)? Obviously, as it has been since 1913, there will always be winners and losers when it comes to the tax code. As such, knowing how to ‘play the game’ is consistently of paramount importance.
In examining the core tenets of the Biden tax plan (as currently published), it seems clear that Joe from Scranton is targeting those earning over $400,000 annually. By contrast, according to Biden, taxpayers earning under $400,000 will experience no change in their federal income tax. Here’s a fun, and semi-related fact: actor Ronnie Reagan was making $400,000 per picture in the 1940s. However, he would only make two movies annually because the marginal tax rate was over 90% on income over $800,000. Perhaps there’s some occultic significance to the $400,000 number of which I am acutely unaware or some payback from Biden for having been pejoratively labeled a “demagogue” by Reagan in his presidential diaries. Whatever the reason for the seemingly arbitrary target, perhaps taxpayers approaching a $400,000 income will choose to “loaf” around like Reagan did after 2 films annually instead of earning more than a soft ceiling amount where earned income begins to quickly vanish into the (202) Area Code.
While it is not as punitive as FDR’s proposed 100% tax on any income over $25,000 in 1942 (coincidentally, this is very close to $400,000 today on an inflation-adjusted basis. But I digress from trying to shoehorn the conspiratorial into this article…), under Biden, those earning over $400,000 could be disgorged of appreciable amounts their earned income. To wit:
- Income tax rates on those earning over $400,000 per year would increase from 35% or 37% to 39.6%. Based on what is currently published, it is unclear whether the $400,000 cap will be identical for both single and joint filers.
- The social security wage base “cap”, currently at $137,700 would be “lifted” for those earning over $400,000. As a mathematical point of reference, the current tax on social security is 12.4% (6.2% for employees and 6.2% for employers). As such, a sole proprietor earning $401,000 under Biden would pay an additional $32,649 of OASDI (social security) tax under the Biden tax plan. A highly compensated executive earning $401,000 would essentially split that increase with his or her employer.
- The PEASE limitation will be restored. Presumably, the mechanics would be identical as they had been in the past: 3% of itemized deductions would be reduced by every $1 of income above a certain dollar amount of income (in this case, $400,000).
- No Qualified Business Income (QBI) deduction for business owners who earn over $400,000. This could hit small business owners particularly hard. Under the TCJA, the QBI deduction allows “pass-through” business owners (owners of partnerships, LLCs, S corporations, and even sole proprietors) to deduct 20% of their business income, such that they are only taxed on the remaining 80% of their income. This effectively reduces the tax bracket for pass-through business income by 20%. For instance, the QBI deduction reduces the top 37% federal income tax rate to 29.6%. Under the TCJA, for those classified as Specified Service Trade or Business (doctors, lawyers etc.), the ability to use the QBI deduction is phased out completely at just under $427,000 (half of that for single filers) of income. As a result, while the Biden tax plan would ‘only’ raise the top tax bracket by 2.6% (from 37% to 39.6%), the removal of the QBI deduction would, for pass-through business owners, result in an additional tax bracket increase of 10 percentage points (from the QBI-adjusted 29.6% under current law, to the QBI-less full 39.6% bracket under the Biden tax plan). That’s a 34% tax increase!
High income-earning non-business owner employees would, ostensibly, be hit the hardest by this $400,000 ceiling. Like actors in the 1940’s, there is very little strategic planning available to the high-income earning W2 taxpayer that would enable him or her to escape the dramatic increase once compensation levels reach $400,000. Moreover, the Biden tax plan calls for tax deductions for contributions to IRAs, 401(k)s, 403(b)s, and other pre-tax accounts to be eliminated and replaced with a new credit that would be equal a specified percentage of the amount contributed to the pre-tax account irrespective of the taxpayer’s income. Thus, outside of investing in tax-favored arenas (oil and gas come to mind) or taking an unpaid 4th quarter sabbatical, tax mitigation planning options will be scarce for highly compensated executives. Conversely, because business owners can alter the manner by which they receive income, with proper planning, they always have a fighting chance of escaping any looming progressive tax dragnet.
Perspective on the amount of income tax Trump actually paid in 2017
Whether Biden’s plan will be able to coerce real estate moguls into paying their fair share of income taxes remains an open question. Based on an examination of the returns released through the felonious IRS leak, it appears that, like others in the real estate biz, Trump’s ability to reduce his income taxes is primarily attributable to his use of depreciation. However, based on the New York Times’s own analysis of Trump’s tax-return data for 2017, Trump paid $7,435,857 in taxes in 2017. If that’s the case, from where does the $750 figure Chris Wallace used to press Trump emanate? Similar to the question of who won the debate, the answer here is a matter of perspective…
The Times says the tax return data demonstrate that Trump’s earnings were negative for the year (i.e., his businesses showed a loss), so he owed $0 in ordinary income taxes. However, he was subject to the Alternative Minimum Tax (AMT), a parallel tax system initially conceived in the late 1960’s to ensure that wealthy people cannot use certain deductions to eliminate their tax liability altogether. According to the Times, “the A.M.T. formula disallowed $45 million in losses that Mr. Trump had carried over from prior years.”
As a result, Trump was left with an AMT bill of $7,435,857. Although there was no way for Trump to avoid paying this tax bill, there were two means by which he could choose to pay it: cash or credit. In this case, Trump selected the ‘credit’ option. The Times chronicles Trump’s use of this credit:
“But tax laws gave him one more line on which to reduce the A.M.T. Mr. Trump had $22.7 million in General Business Credit, much of it carried forward from prior years, that he could apply. The credit is a smorgasbord of tax incentives and givebacks to business owners, and in Mr. Trump’s case they ranged from credits of $322,926 for Social Security and Medicare taxes paid on employee tips to at least $1.5 million related to rehabilitating the Old Post Office in Washington.
The business credit cannot be used to get a refund; it can only be applied against taxes owed. Mr. Trump had more than enough to cancel out his $7,435,857 tax bill. But on the Form 3800 for the General Business Credit, his accountants subtracted $750 from his allowable credit. Why they did that is not clear. But the result was a total federal income tax liability of $750.”
To restate the above in summary form: Trump paid his 2017 tax bill in full by using $7,435,107 of his accumulated tax credit and $750 of his cash.
The Trump tax story—separate from Trump’s politics or even Trump himself—is inspirational to many business owners. Naturally, for most, inspiration quickly mutates into aspirations of learning the secrets of how one can legally pay less tax to the government. This sentiment transcends the semantics of politically-motivated perspectives on whether Trump actually paid almost seven-and-a-half million in taxes or only $750. To the pragmatist, this story sparks a more interesting tactical discussion surrounding the use of business losses—particularly in light of the loss carry-back rules memorialized in the CARES Act. Even with the ability to carry-back Net Operating Losses (NOLs) for five years granted by the CARES Act, does it make sense for a business owner to do so? Obviously, if a taxpayer can be severely punished financially for earning over $400,000 under a near-future Biden tax plan, wouldn’t it be more valuable to maintain those NOLs in reserves (i.e., carry them forward) and use them to engineer the reduction of taxable income to sub-$400k levels rather than expend them in past tax years (i.e., carry them back) as the CARES Act sanctions?
Real economic losses caused by government-imposed shutdowns are not opportunities—they are often tragedies for many involved. However, working with an experienced tax attorney who can often find legal yet latent deductions and/or show a business owner how to restructure the way he or she receives income can create substantial economic benefits and foster future income protection. Trump’s 2017 tax return is illustrative of this dichotomy—were his businesses experiencing real economic losses or “tax” losses created by depreciation and other planning?
Of course, merely knowing the rules of the tax “game” is only part of the battle. Subsequent considered, informed judgments are strategically indispensable to ultimately winning it. For example, if the Biden tax plan eliminates the 1031 tax-deferred exchange (i.e., selling a property and “exchanging” it for another property and deferring the tax liability on the sale of the 1st property) along with the step-up in basis for capital assets held at death, will we see the use of strategies such as accelerated depreciation (which often reduce an asset’s basis to $0) decline? Only time will tell.
Professionally, my interest in viewing Trump’s tax returns is more calculated: I want to know what specific strategies his team has implemented to see if there is anything that we are not currently utilizing to help our clients pay only the tax that they are legally required to pay. We can then modify those strategies (if need be) and ultimately incorporate them into the suite of restructuring and income tax planning techniques from which our clients can select.
Personally, I’m much more interested in seeing the tax returns of public servants who became millionaires while serving the public than those of billionaires that became public servants.
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Christopher Hynes is the SVP of Tax Consulting for Tax Law Solutions. He is a knowledgeable and experienced Tax Attorney and Certified Financial Planner, which makes him part of a select group of attorneys who are also CFPs (there are less than 2,000 in the US). Chris is also an adjunct faculty member of Massachusetts Continuing Legal Education (MCLE). Chris has served as the National Director of Financial Services for Meridian Medical Practice Solutions, as Chief Finance Editor for Today’s Practice magazine, as radio host “Your Money Live Boston”, and has also published and been cited in such publications as Fox Business News, Bloomberg Radio and Kiplinger’s Personal Finance. Most recently Chris was a panelist at the Texas-China summit regarding Tax-Efficient Investing in the United States.