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Annette Nellen

Tax reform calculations: Helping clients see direct financial effects

Illustrating the effect of tax reform proposals can help practitioners explain the proposals to their clients.

May 10, 2012
by Annette Nellen, Esq., CPA

The news during this presidential election season has frequently focused on the fairness of the current tax system, as well as the amount of revenue raised under it. Many proposals for revamping the current system have been advanced from all sides of the political spectrum. It is difficult for many people to understand how these proposals might affect them. Calculating the effect of these proposals on clients’ specific tax situations can be a valuable client service.         

Client Service Idea for the 2012 Filing Season,” Tax Insider, April 12, 2012, suggested that practitioners consider using 2011 tax return data to help clients understand one particular tax reform proposal (S. 727, Bipartisan Tax Fairness and Simplification Act). That article provided a template for that proposal along with information on how to explain the calculation to clients and cautions to exercise in doing so. This article provides illustrations for three more reform proposals applicable to individuals. Links to the proposals are provided for obtaining additional background and details on the particular proposals.

CBO option for a reduced charitable contribution deduction

A March 2011 Congressional Budget Office (CBO) report, Reducing the Deficit: Spending and Revenue Options, lists and explains possible options for increasing tax revenues. These options are not necessarily recommendations of the CBO, but rather illustrations of ways to generate revenue.

Option 6 (p. 150) suggests that charitable contributions be allowed only to the extent they exceed 2% of adjusted gross income (AGI). This calculation is similar to the existing limitation on miscellaneous itemized deductions (Sec. 67), which limits the deduction  for certain expenses, such as unreimbursed employee business expenses and tax preparation costs, to the extent they exceed 2% of AGI.

Calculation:  
Charitable contributions from Schedule A (1) ___________________
Less: AGI  × 2%   (2) ___________________
= Allowable charitable contribution deduction  (3) ___________________

Recalculate taxable income using the new charitable contribution deduction from line (3).

A recalculation of taxable income should also apply the limitation of Sec. 68, Overall limitation on itemized deductions, which is scheduled to return in 2013. The CBO estimates that the applicable Sec. 68 inflation-adjusted amount for 2013 will be $174,500. If AGI exceeds this amount, total itemized deductions must be “reduced by the lesser of (1) 3 percent of the excess of adjusted gross income over the applicable amount, or (2) 80 percent of the amount of the itemized deductions otherwise allowable for such taxable year” (the Pease limitation). Under Sec. 68(c), “For purposes of this section, the term ‘itemized deductions’ does not include (1) the deduction under section 213 (relating to medical, etc. expenses), (2) any deduction for investment interest (as defined in section 163(d)), and (3) the deduction under section 165(a) for casualty or theft losses described inparagraph (2) or (3) of section 165(c) or for losses described in section 165(d).” Sec. 68(d) provides that the Pease limitation is applied after the application of any other limitation on itemized deductions.

Alternative calculation: The effect of this CBO option can also be determined on a client’s recent tax return by multiplying line (2) above by the client’s marginal tax rate (which is the highest tax bracket they are subject to for the year). The product is the additional tax owed under this option.

The CBO projects that this change would increase federal revenues by $86.2 billion over a five-year period.

CBO option to limit tax benefit of itemized deductions to 15%

CBO Option 7 (pp. 151–152) “would limit the extent to which taxes can be reduced by itemizing to 15% of the deductions’ value.” Thus, the tax savings from itemized deductions cannot exceed 15%.

An approximation of the additional tax owed under this CBO option can be obtained with the following calculation:

Marginal tax rate ___% (highest tax bracket used in calculating client’s tax)
Less   (15%)
Difference   

  Y

Itemized deductions originally claimed   $__________
  × Y%
Additional tax owed   

$__________

Alternative calculation:

Taxable income without any itemized deductions (1) $_____________________
Tax on (1)  (2) $_____________________
Less: Itemized deductions × 15% (3) $_____________________
= Tax under CBO Option 7    (4) $_____________________

The additional tax owed under Option 7 can be determined by comparing (4) to the tax calculation on the filed return. The CBO projects that this change would increase federal revenues by $460.1 billion over a five-year period and affect about 25% of individual taxpayers.

President Barack Obama’s fiscal year 2013 proposal: The administration’s fiscal year 2013 revenue proposals include one similar in concept to CBO Option 7, but it is applicable to a greater number of tax preferences. This proposal would limit not only itemized deductions but also other specified deductions and exclusions to generating a tax benefit of no more than 28%. From the fiscal year 2013 Greenbook (pp. 73–74):

The income exclusions and deductions limited by this provision would include any tax-exempt state and local bond interest, employer-sponsored health insurance paid for by employers or with before-tax employee dollars, health insurance costs of self-employed individuals, employee contributions to defined contribution retirement plans and individual retirement arrangements, the deduction for income attributable to domestic production activities, certain trade and business deductions of employees, moving expenses, contributions to health savings accounts and Archer MSAs, interest on education loans, and certain higher education expenses.

This proposal would apply to itemized deductions after they have been reduced by the statutory limitation on certain itemized deductions for higher income taxpayers.

Beginning with the 2012 tax year, individuals who work for larger employers will be able to determine the cost of employer-sponsored health insurance because it must be reported on the employee’s Form W-2 under Sec. 6051(a)(14). The other items of tax preference should be available from employer-provided reports and the individual’s tax return. Calculations similar to those shown above for CBO Option 7 can be used to determine the additional tax owed.

H.R. 1040, Freedom Flat Tax Act

H.R. 1040 is modeled on the flat tax created by Robert E. Hall and Alvin Rabushka in the early 1980s. This flat tax is not an income tax, but a consumption tax in the form of a modified subtraction method value-added tax (VAT). Under H.R. 1040, the business tax calculation allows a deduction for wages (but not fringe benefits or FICA taxes). Normally, under a VAT, wages are taxable (because they are part of the value added by the business). Hall and Rabushka’s plan would allow businesses to deduct wages, but then the wages would be taxed to the employees at the same flat tax rate. Individuals would be allowed a fairly large standard deduction based on marital status and number of dependents to make the tax less regressive.

Under H.R. 1040, individuals would be able to make an irrevocable election to be subject to the flat tax rather than the regular tax and alternative minimum tax (AMT). H.R. 1040 calls for repeal of estate and gift taxes.

Calculation of the individual flat tax:

Wages   $____________
Retirement distributions  $____________
Unemployment compensation $____________
Taxable income of dependent children
under age 14 
$____________
Less standard deduction  ($____________)*
Taxable income 

$____________
× 17%**

Tax      $____________

* Standard deduction:

Filing Status

Standard Deduction

Married filing jointly or surviving spouse

$30,320

Head of household

$19,350

Single

$15,160

Additional standard deduction for each dependent who is a qualifying child not required to file his or her own return

$6,530

** The tax rate is 19% for the first two years an individual uses the flat tax.

Because the H.R. 1040 flat tax is a consumption tax, investment income, such as interest income, dividends, and capital gains, are not subject to tax. Under the H.R. 1040 flat tax, there are no special deductions or tax credits for individuals, and there is no AMT.

An individual’s business tax: If an individual has income from a sole proprietorship or farm (Schedules C or F), the business tax portion of the flat tax would need to be calculated and paid on that business activity. If an individual has rental property, this would also appear to require a separate business tax return.

Individuals owning interests in partnerships or S corporations would not include their distributive share of that income in their individual tax calculation. Under the flat tax, these entities would pay the flat tax for businesses, which would reduce the distributive share of the owners.

For tax planning purposes, under the flat tax, any business and its owners would want to be sure that enough wages were paid (and earned) to enable the employee-owners to fully use the standard deduction.

Additional costs: H.R. 1040 may cause employers to eliminate or reduce employee fringe benefits, such as medical or life insurance, if they are no longer tax deductible. Thus, employees may have increased costs of obtaining them on their own.

Additional considerations

Recalculating an individual’s last filed tax return using changes of any tax reform proposal can help clients understand the proposals better both in terms of direct financial impact and changes in planning considerations. For example, charitable contribution planning might change under CBO Option 6 to bunch contributions into years when AGI is expected to be lower. In addition to understanding the direct effects on clients, to best understand any proposals, consideration must also be given to the effects on employers, state governments, federal deficits, and interest rates, and even compliance and recordkeeping costs.

For more information on tax reform and proposals, see the author’s tax reform website.

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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.