TRA of 2014 – Tax Rate Changes (Ordinary Income)

Title I —> Subtitle A —>Section 1001
Pages 14-34 of the Tax Reform Act draft
Pages 1-3 of the Ways and Means explanation
JCT Technical Explanation JCX 12-14, pages 2-9 (pdf pages 7-14)

The current 2014 tax rate brackets are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%, all on taxable income.  Under the TRA, these rates are compressed into two rates, one at 10% and the other at 25%:

SEC. 1001. SIMPLIFICATION OF INDIVIDUAL INCOME TAXRATES.
(a) IN GENERAL.—Section 1 is amended to read as follows:
‘‘SEC. 1. TAX IMPOSED.
‘‘(a) IN GENERAL.—There is hereby imposed on the income of every individual a tax equal to the sum of—
‘‘(1) 10 PERCENT BRACKET.—10 percent of so much of the taxable income as does not exceed the 25-percent bracket threshold amount,
‘‘(2) 25 PERCENT BRACKET.—25 percent of so much of the taxable income as exceeds the 25-per17 cent bracket threshold amount, plus,…

These are the tax rates applied to taxable income.  The 10% bracket tops off at $71,200 for taxpayers filing married filing jointly, and one-half of that ($35,600) for all other individual taxpayers.  (The filing statuses of single, head of household, and married filing separately would be merged into this status.)  All taxable income exceeding this amount is taxed at 25 percent.

With incomes above $450,000 for married filers and $400,000 for everyone else, an additional tax kicks in:

‘‘(3) 35 PERCENT BRACKET.—10 percent of so much of the modified adjusted gross income (as defined in section 2) as exceeds the 35-percent bracket threshold amount.

Note the amount on which the rate is applied – modified adjusted gross income, which removes some deductions that are allowed in computing taxable income.  This is called a “35 percent bracket” to lead the reader to believe that this is one tax, a hybrid of the 25% tax on taxable income plus the 10% tax on modified AGI.  It’s possible it was framed this way to avoid the negative optics of this being labeled an additional tax.  Attached is a graphic showing the comparison of the tax rates.

Tax rate comparison

“Modified adjusted gross income” is computed beginning with adjusted gross income, and then adding to it some items that are normally excluded from adjusted gross income (for example, foreign earned income and state and local municipal bond interest).  Notably, this income is reduced by something called “qualified domestic manufacturing income”.  There’s a lot of language in the draft legislation to make sure taxpayers don’t use this for other than its intended purpose, which is to allow income from an active manufacturing businesses that are operating domestically to avoid the 35% bracket.  This exclusion from the 35% bracket would effectively replace a provision in the current Code that reduces the tax rate on “qualified domestic activities income” (IRC § 199).  Section 3122 of the TRA would transition and repeal the QPAI deduction over the next three years.

Modified adjusted gross income is also used to measure a 5% tax when income exceeds a threshold amount ($300,000 for married filing joint taxpayers and $250,000 for all other individuals).  This is a phaseout, meaning that for every dollar of modified AGI exceeding the threshold amount, an additional tax of 5% of modified AGI is imposed to negate the 10% tax bracket on taxable income.  The maximum that is phased out is 15% (the difference between 25% and 10%) multiplied by the income taxed below the 25% threshold.  For married filing joint taxpayers, taxpayers may be subject both to this phaseout and the 35% tax bracket – for 2014, the phaseout for joint filers ends at $513,600, above the $450,000 threshold on the 35% bracket.  A graphic showing the effect of the phaseout and 35% bracket are attached.

Phaseout joint

Phaseout others

Under both the current code and in the TRA, tax policy frowns upon parents using their minor children as conduits to receive investment income at lower tax rates.  Currently, the Code addresses this by taxing certain unearned income (i.e., investment-type income that isn’t wages or some other type of compensation for the child’s services) on the child’s return at the highest tax rate of their parents’ income.  Basically, it treats this income as if it were the parents’ income.

The TRA’s approach to this reflects the same concern, but with fewer tax brackets in play, the proposed treatment is different.  The draft legislation treats the “net unearned income” in the same way as income earned by an estate or trust.  The Joint Committee on Taxation has two helpful examples:

Example 1.—Assume a child to whom the “kiddie tax” applies has $60,000 taxable income (and modified AGI) of which $50,000 is net unearned income. Assume the 25-percent bracket threshold amount for the taxable year is $35,600 for an unmarried taxpayer (other than a
child subject to the “kiddie tax”), and the 35-percent bracket threshold for a trust is $12,000.

The child’s 25-percent bracket threshold is $10,000 ($60,000 less $50,000) and 35-percent bracket threshold is $22,000 ($10,000 plus $12,000). Thus, $10,000 is taxed at a 10-percent rate, $12,000 is taxed at a 25-percent rate, and $38,000 is taxed at a 35-percent rate.

Example 2.—Assume the same facts as in Example 1 except that the amount of the child’s net unearned income is $20,000 (rather than $50,000).

The child’s 25-percent bracket threshold is $35,600 and 35-percent bracket threshold is $52,000 ($40,000 ($60,000 less $20,000) plus $12,000). Thus, $35,600 is taxed at a 10-percent rate, $16,400 is taxed at a 25-percent rate, and $8,000 is taxed at a 35-percent rate.

Finally, the TRA proposes a change to the method of computing inflation when adjusting the tax brackets (and other items that will be discussed later).  Currently, the Code requires the IRS to adjust the income tax brackets upward.  Prior to the next tax year, the IRS will publish the inflation-adjusted amounts of income, deduction, etc. (such as Revenue Procedure 2013-35).  The measure to determine the new brackets is done using the Consumer Price Index – All Urban (CPI-U).  This is one of the indexes maintained and used by the Department of Labor.

The draft legislation would change that method to require the IRS to use a different index, the Chained Consumer Price Index (C-CPI-U).  The mechanics of each method don’t concern us here, but the effect of choosing the chained CPI would slow the increase of each tax bracket.  Back in the 1970s, before any CPI index was used to move the brackets up, high inflation caused an effective tax increase.  If an index that slowed the growth of these tax brackets, more income could be subjected to a higher bracket than using the current method.

Up next:  the TRA changes to the treatment of capital gain and dividend income.

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