By David Acharya, Partner at AGI Partners LLC and EVP of ACG New York
On April 26, 2017, President Donald Trump made his proposal for what is known as the “biggest tax cut” in U.S. history — with cuts that would benefit businesses and all income earners. This proposal will rival President Ronald Reagan and President John Kennedy tax cuts enacted in their respective administrations.
While the proposal affects all earners both individuals and businesses, I will focus on the effects of ACG NY’s community – middle market businesses.
Key Proposals affecting Middle Market businesses:
Reduction of Corporate Income Taxes
President Donald Trump’s plan to cut the tax rate to 15% for so-called pass-through businesses would be a significant change to the tax code (as opposed to current pass-through income taxed at an individual tax rate which can be as high as 39.6%).
This is aimed at small businesses, but pass-through treatment also applies to a lot of private equity funds as well as other funds (e.g., ones structured as LLC’s). Moreover, funds organized as limited partnerships likely would restructure to qualify as pass-through entities for tax purposes (or at least firms would be sure to raise the next one that way). In short, such fund managers could pay a flat 15% tax on all their income, including annual management fees on which they currently pay individual rates. This basically makes the carried interest debate irrelevant. The clear majority of middle market firms use pass-through structures.
I believe that lowering the tax rate for the business income of partnerships, S Corporations and limited-liability companies would spur U.S. business growth and job creation.
Reduction of Personal Income and Income Tax Brackets
President Donald Trump has proposed cutting Income Taxes from 7 brackets to 3 brackets. As part of the simplified brackets, Mr. Trump has also proposed doubling the standard deduction for individuals. That change would increase the deduction from the 2016 levels of $6,300 for single filers and $12,600 for married couples filing jointly. Doubling the deduction would greatly increase the number of people who take the standard deduction thus further simplifying tax returns going forward. Under the plan, deductions for mortgage interest and charitable contributions would be protected. The two deductions are among the most popular for individual U.S. taxpayers, making them two of the costliest for the federal government. Under current law, for 2017, the estate and gift-tax exemption is $5.49 million per individual. President Trump would repeal the estate tax entirely under his plan.
This will simplify tax planning for individuals and increased individual after-tax income which will then be used for spending on products/services and investments including retirements.
In addition, I believe that these breaks and estate tax exemptions will further increase the supply of middle market companies that are brought to market for sale. This will further increase the pipeline of investment opportunities for private equity funds.
Business Breaks and Interest Deductibility
President Trump has continued to express his support for writing off capital investments and to an extent, business interest deductibility. This will continue to encourage investing in businesses and infrastructure. While there has been discussion on eliminating business interest deductibility, I believe this will not pass due to many industries having a powerful interest in seeing the business interest deductibility continuing.
The continuation of these breaks and deductibility is meant to create greater incentives for middle market firms to invest capital to grow their businesses.
Lower Capital Gains Tax
Under the plan, the top federal capital gains rate is cut from 23.8 percent to 20 percent. This is achieved by eliminating a 3.8 percent tax that is used to fund the Affordable Care Act.
The reduction is meant to create greater incentives for people to invest as well as improve the after-tax return of the sale of their businesses.
Implementing a Territorial Tax System
This area has not gotten as much press as other areas but I believe that global industrial and technology companies are among the companies pressing for President Trump’s proposal to implement a territorial tax system, in which the U.S. only taxes profits generated in the country, leaving overseas profits untouched except by those countries. Currently, the U.S. is unusual in taxing firms’ overseas profits if the proceeds are brought to the U.S., a system that has encouraged U.S. companies to book profits in low-tax foreign jurisdictions and leave them there. (Companies typically must pay the difference between what they already paid in foreign tax jurisdictions and the full U.S. tax bill for the repatriated profits.) In addition, it has introduced odd ways to manage cash such as leaving cash overseas and borrowing domestically (e.g. Apple Inc.).
About one in five companies in the Russell 1000 index (public companies including middle market) generate much of their sales outside the U.S., and more than half receive at least some revenue from abroad. U.S. firms hold about $2.6 trillion overseas, the nonpartisan congressional Joint Committee on Taxation estimates. A movement towards territorial system will eliminate a need for inversions or trapped cash.
The implementation has greater incentives for returning the capital to the US thus benefitting the US tax system and simplifying tax returns for middle market companies. The longer-term benefit for middle market companies is that the US system will have more capital to invest in smaller but growing business in a stronger US economy.
I believe that middle market businesses should continue to be bullish on President Trump’s tax proposal.