Sens. Rubio and Lee Offer Tax Reform Proposal

March 11, 2015

pic-tax-reformLast week, Republican Sens. Marco Rubio (Fla.) and Mike Lee (Utah) released a detailed plan to overhaul the existing tax code. The Rubio-Lee plan focuses largely on the business portion of the code, and only offers modest improvements to the individual side. Some highlights of the proposal are listed below.

Individual Tax Rates on Ordinary Income

Under current law, there are seven rates on ordinary income — 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. The Rubio-Lee follows in the footsteps of earlier plans offered by Simpson-Bowles and Mitt Romney by consolidating the seven brackets into only two. All income below $75,000 if single, and $150,000 if married filing jointly would be taxed at 15 percent, while every dollar in excess of those thresholds would be taxed at 35 percent.

Individual Tax Rates on Interest, Capital Gains, and Dividend Income

Under current law, interest income is taxed at ordinary income tax rates as laid out above. Long-term capital gains and qualified dividends, however, are subject to preferential rates—ranging from zero percent to 23.8 percent.  Determining the appropriate rate requires navigating a complex set of rules and thresholds. Instead, the Rubio-Lee plan would exempt all interest, dividends, and capital gains from income tax, regardless of level of income.

Corporate and Pass-Through Entities

C corporations pay taxes on their income, and their owners (shareholders) pay a second layer of taxes on dividends and capital gains—a ‘double taxation.’ This raises the effective tax rate on capital, with the tax rate reaching 35 percent, currently the highest in the industrialized world. Rubio-Lee would fix this problem by eliminating the second layer of tax. Shareholders would not pay tax on their capital gains or dividends.

S corporations and partnerships, however, are “flow-through entities,” meaning that unlike C corporations, income earned by an S corporation or partnership “flows through” to the individual owners, who pay the tax on their share of the entity’s income on their individual tax return. The top rate on ordinary income is currently 39.6 percent; as a result, the income of S corporations and partnerships is sometimes taxed at a higher rate than a C corporation. The Rubio-Lee plan sets the rate on all businesses (C corporations and pass-throughs) at 25 percent.

Estate Tax Provisions

At the end of 2012, the estate tax exemption – set at $5 million in 2012 – was slated to revert to $1 million in 2013 in the absence of Congressional action, while the estate tax rate would jump from 35 percent to 55 percent. Eventually the president negotiated with Congress and agreed to a $5 million exemption amount and a 40 percent tax rate for 2013 and beyond. He made those amounts permanent, with the exemption indexed for inflation. As a result, the exemption is $5.43 million in 2015. The Rubio-Lee plan would abolish the estate tax entirely.

Depreciation and Expensing

Under current law, businesses are not permitted to take a current deduction for purchases that will benefit the business in some future period. For example, the cost of inventory — whether purchased for resale or produced — must be capitalized and cannot be deducted until sold. In addition, if a business purchases assets —machinery, equipment, furniture and fixtures or buildings –to be used in its business, the cost of the assets must be capitalized and depreciated over the period of time the business stands to benefit from the use of the asset. The Rubio-Lee plan would permit an immediate deduction for the full cost of inventory, whether purchased or produced, as well as any business assets.

Itemized Deductions

A significant number of individual taxpayers itemize their deductions because the total of those deductions —mortgage interest, state and local income taxes, charitable contributions, and real estate taxes – exceeds the “standard deduction” available to every taxpayer of $6,300 if single and $12,600 if married filing jointly. Under the Rubio-Lee plan, the “either-or” of the current itemized deduction – standard deduction decision would disappear. Taxpayers would receive a credit — rather than a deduction — of $2,000 if single and $4,000 if married filing jointly. In addition to the credit, taxpayers would be entitled to a modified mortgage interest deduction and a charitable contribution deduction. All other itemized deductions will be eliminated.

International Tax Reform

Currently, the income of foreign subsidiaries of U.S. corporations is taxed under a “deferral” system. This means that the income earned by the foreign subsidiary is generally not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend. The Rubio-Lee proposal would move to a full territorial systems; leaving income earned by foreign subsidiaries of U.S. corporation to be taxed only by the jurisdiction in which it is earned, with no second U.S. tax imposed when the foreign income is repatriated to the U.S.

For the complete proposal, please click here.

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