Ines Zemelman, EA 01-Dec-16
The election is finally over, but the discussion around potential changes from incoming administration has only just begun. There has been much rhetoric throughout the campaign about big changes to the Tax Code. Let's review the potential points of discussion and how Americans living abroad may see their tax bills affected by President-Elect Trump's proposals.
The US Tax System
The United States has an “extraterritorial” system for taxes, which is why changes to tax rates and tax rules in the United States impacts Americans who are living abroad.
The United States taxes their citizens on all of their income worldwide, regardless of where they live, although the IRS allow expats to utilize the Foreign Earned Income Exclusion (FEIE) to exclude some of their earnings from foreign sources from their taxable income. For the 2015 tax year, the allowable exclusion was USD 100,800, which is adjusted each year for inflation. Amongst other tools, there is also the opportunity to exclude additional income via the foreign housing exclusion.
This system is different than that of most countries, which typically allow their people to pay taxes based on the country they reside in, with some exceptions.
Potential Significant Changes & Impacts
When campaigning, Trump proposed significant changes to tax rates for individuals, including consolidating the current seven tax brackets into three, at rates set at 12%, 25%, and 33%. Trump also proposed that the alternative minimum tax (AMT), along with estate taxes, be repealed.
Some experts have estimated that US taxpayers making between USD 48,000 and USD 83,000 per year will save around $1,000 annually if Trump’s plans are implemented. Those with incomes over USD 3,700,000 per year would see USD 1,000,000 each year in savings.
We find such estimates extremely speculative. There are too many moving parts in the proposed regulations. Certain changes, if taken separately, may have a detrimental effect. For example, one of the proposed changes is the increase of standard deductions for married couples to $30K with elimination of personal exemptions. Increase of standard deductions from $12,600 to $30K sounds great for taxpayers who do not want to itemize deductions.
Importantly - elimination of personal exemptions will disadvantage families with children. A married couple without children will see a decrease of taxable income by $10,000K while a couple with 3 children will have $3K increase in taxable income. Currently they deduct $33K through standard deductions and 5 personal exemptions whilst under the new rules they would only deduct $30K.
Changes in Taxation of Pass-Through Entities
The bigger changes under the Trump plan may come in the treatment of so-called “pass through” taxation. Under the current law, income earned by S-Corporations, LLC and Partnerships is allocated to the owners, who pay the corresponding tax at the individual level, based on the applicable individual rates laid out above.
Trump suggests the unified business rate of 15%, meaning not only would corporations pay tax at that rate, but all business income – even the income earned by an individual from an S corporation, partnership, or sole proprietorship and reported on the individual’s tax return — will be subject to the same 15% rate. This change would not affect low income taxpayers but taxpayers in higher tax bracket earning business income would experience a drop in the top tax rate on business portion of their income from 39.6% to 15% under the Trump presidency.
This change has a potentially high impact on the tax obligations of self-employed individuals living in low-tax countries with income exceeding the foreign earned income exclusion cap (approximately $100K). Under the current law, self-employment income remaining after the foreign earned income exclusion is taxed at the marginal tax rate. A potential drop in the tax rate to 15% would yield significant tax savings.
Elimination or Partial Repeal of the Affordable Care Act (Obamacare)
This change, if implemented, will have the highest impact on U.S. expats. Partial repeal of the Affordable Care Act would include a repeal of the 3.8% tax on Net Investment Income. The Net Investment Income Tax (NIIT) is an apparent incident of double taxation. Even if tax paid on investments in the resident country was higher than the income tax paid in the US, the NIIT surcharge of 3.8% cannot be offset with the excess of foreign tax credit. Individuals subject to NIIT tax must first pay the full tax on investment in the resident country. Then, U.S. income tax on investments may be offset with the foreign tax credit, however, the surcharge of 3.8% remains payable to the U.S. For example, an individual with $100K in capital gains upon sale of a foreign rental property, would have his/her tax obligation lowered by $3,800 with a repeal of NIIT.
No More Estate Tax
Under current law, estate value in excess of $5.45 million is subject to 40% tax. The beneficiaries of the estate bequeath the assets with a tax-free, “stepped-up” basis.
President-Elect Trump’s proposal would eliminate the estate tax entirely, yet modify the step-up basis for estates in excess of $10M. Te appreciation inherent in the assets of an estate valued in excess of $10 million will become taxable and no longer have a privilege of step-up basis hike. However, tax will be paid only when the beneficiary sells the assets; the assets won’t be taxed immediately upon death.
Bringing Money Back to the US
Trump also plans to reduce tax rates for corporations, and give one-time tax breaks to companies in the US that keep several hundred billion dollars of their profits sitting overseas to help reduce their tax bill in the US. The discussion of repatriation of corporate profits offshore is not as relevant for individual taxation of Americans abroad, but there is a great deal of discussion of the ripple effect of such a move and important to stay on top of.
It is important to remember that at this stage such proposals are pure conjecture and the commentary of pros and cons of potential outcomes has generally been politically driven. Much of the discussion has been focused around corporate and estate tax, issues not concerning the majority of the 8 million US expats globally. Pundits and tax professionals have a responsibilty to analyze potential outcomes, but as readers it vital to keep in mind that all commentary is tentative to new information.