President Donald Trump recently announced the massive changes that he wants to make to the Internal Revenue Code. The announcement consisted of broad parameters with no details as to implementation. In summary, the plan is to reduce the corporate tax rate to 15 per cent, the “pass through” tax rate to 15 per cent, to impose a low tax rate (the amount is still undetermined) to encourage US corporations to bring international profits earned in prior years back to the US, to eliminate the corporate income tax on future profits earned outside the US, repeal the estate tax, reduce the current seven tax brackets for individuals to three (10 per cent, 25 per cent and 35 per cent) to repeal the Obamacare tax surcharges on salary and investment income, to limit itemised deductions to mortgage interest and charitable contributions and to increase the standard deduction to $24,000.

Many of these changes are at odds with prospective tax law changes that have already been announced by the House Ways and Means Committee. And the Senate has not yet announced what their priorities are. While it appears certain that there will be massive tax reform by the fall, how it will look is uncertain, especially in light of the recent spending bill passed on April 28.

The Republicans have a majority in the House, Senate and White House and on paper should be able to pass any legislation that they want. In reality, there is so much disagreement between them that to keep the government running the Republicans needed a significant number of Democratic votes, at a cost of significant current and future concessions, to pass the spending bill last week.

What do large corporations and small businesses have in common?

They each employ 50 per cent of the US workforce. What they do not have in common is the same tax rate. Currently, a large corporation is taxed at a flat 35 per cent on taxable income whereas a small business will pay anywhere from 10 per cent to 39.6 per cent on their profits.

Under the White House proposal a small business that operates as a Subchapter “S” corporation, Limited Liability Company or Limited Liability Partnership would pay the same 15 per cent tax rate as proposed for Apple, Google, Ford, etc. If you ignore other tax issues associated with these types of entities, there is an apparent opportunity or loophole for individual taxpayers to pay the same 15 per cent tax rate.

Background

Currently, the IRS has an ongoing disagreement with large companies who need thousands of literate low to medium-paid employees. Think of banks, construction companies, industrial farms, race tracks, internet entities, etc. An employer who has hired an employee must pay a 7.65 per cent Social Security/Medicare tax on salary, in many cases health insurance, retirement benefits, vacation pay, sick pay, life insurance, etc.

These expenses could add 30 to 35 per cent to the labour cost. To avoid these expenses many of these entities classify their employees as “contractors” or “self-employed”. This shifts the burden of the 7.65 per cent Social Security/Medicare tax, healthcare, life insurance to the employee, oops, individual.

This practice is so pervasive that the IRS has developed a form for individuals to file with their tax return that simply states that if you are an employee and your employer is treating you as a “contractor” simply give us the details and we will investigate on your behalf.

What is the tax savings opportunity?

The opportunity is the possibility of paying a 15 per cent tax on your earnings instead of 25 or 35 per cent. As discussed above, many employers will welcome the opportunity to hire you as an “outside contractor”. Your potential tax savings as an “outside contractor” will be the difference between the additional costs you will incur less the amount you will save by being in a lower tax bracket. It might be worth the cost of incorporating, filing an annual federal and state corporate income tax return and incurring accounting and legal fees.

In prior years, this approach has been tried by professional athletes, individuals in the entertainment business, etc, with all being disallowed by the Internal Revenue Service who argued that the individuals did not meet the standard for a self-employed individual and were in fact employees. The open question is whether tax reform, when finalised, will close this potential loophole?

Tax return preparation

One of the stated goals of the pending tax reform, per President Trump, is to put H&R Block out of business. Ostensibly, 90 per cent of US taxpayers should be able to prepare their own tax return once the legislation is passed. As itemised deductions will likely only consist of mortgage interest and charitable contributions in the future, it is likely that if your mortgage is less than $500,000 you will use the standard deduction and can prepare your own tax return for free by going to the IRS website and clicking on “free file”.

Given that the government has years of tax return statistics available for research and “what if” computations, the 90% is likely a realistic number.

Territorial taxation

What was not discussed is whether the US will join the rest of the world and tax entities (and individuals) only on income earned in the US.

Stay tuned.

Disclaimer: pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (I) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner. The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the President of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com