Tax Reform Act of 2014 – Capital Gains and Qualified Dividends

Title I —> Subtitle A —>Section 1002
Title I —> Subtitle E —>Section 1405
Title III —> Subtitle G —>Section 3621
Pages 34-39, 159-160, 663-676 of the Tax Reform Act draft
Pages 3, 35, 120 of the Ways and Means explanation
JCT Technical Explanation JCX 12-14, pages 15-22, 62

To explain the changes in how capital gain is treated under the TRA, a few things need to be said at the outset:

  • The current tax code includes preferential treatment of income from the sale or exchange of a capital asset, and for certain dividends.  The reason for this involves a conscious tax policy to encourage investment and growth.
  • A capital asset is defined as much by what it is not as by what it is.  In the JCT explanation, a capital asset is described as “a capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, (2) depreciable or real property used in the taxpayer’s trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, (5) certain U.S.publications, (6) certain commodity derivative financial instruments, (7) hedging transactions, and (8) business supplies.”  Capital assets can include things like equipment used in the production process, livestock (if your business is farming or ranching), and shares of stock in your business.
  • In recent years, economists and policy pundits have debated over whether certain private equity income, referred to as “carried interest”, should be taxed at the ordinary income rates, rather than the capital gains rate.  The reasoning behind this is that in these transactions, where the investors buy shares in a company, exercise some reforms to make the company more valuable, and receive their compensation when they sell their now more valuable stock, is really compensation for the services they performed, and should be treated as ordinary income.
  • Effective beginning in 2013, the current code imposes a 3.8% tax on “net investment income”.

The TRA would remove this preferential rate structure, and put in its place a deduction for 40% of “adjusted net capital gain” from gross income.  Excluded from this definition is investment income, which targets the carried interest income to exclude it from this preferential treatment.  The Ways and Means explanation describes this switch as a slight tax improvement for taxpayers.  For taxpayers in the 35% bracket, the 40% deduction would reduce the effective rate on this income to 21% (60% times 35%) which, when added to the 3.8% tax on net investment income, produces an top effective rate of 24.8, similar to the top effective rate of 25 percent under current law.

But like with all of these new provisions, this has to be taken in context.  Section 1405 of the TRA would remove the deduction for state and local income taxes for most situations, which will bump up the effective tax rate.  The Tax Foundation’s early analysis explains:

When you combine the new federal tax rate on capital gains and dividends with state and local taxes, taxpayers in some states would need to pay an effective marginal tax rate of over 38 percent on capital gains and dividends. The U.S. average top marginal capital gains tax rate faced by taxpayers is 30.9 percent, 30.8 percent for dividends. Both of these rates are 2.2 percentage points higher than current law.

Additionally, to address the situation of carried interest, Section 3621 of the TRA carves out an exception where gain from certain partnership income (it takes 14 pages to specify) is treated as ordinary income and not capital gain income.  As Camp explained in a Wall Street Journal column the day of the release:

We can clean up provisions like “carried interest” that allow certain private-equity firms to get the investment-income tax rate on what anyone else would call normal wage income. We’ll also put an end to special depreciation benefits related to corporate jets and close, once and for all, the infamous “John Edwards” loophole that allows a select few to avoid employment taxes on their income. The revenue gained from that provision, and many others like shifting to Roth-style retirement accounts for those contributing more than $8,750 (only 5% of the workforce) can be used to lower tax rates across the board.

Up next: changes to the standard deduction, child tax credit, and personal exemption, starting in Section 1101.  Section 1003 (pages 40 through 59 of the draft legislation) are technical provisions to clean up other sections of the Code to reflect the changes described in Sections 1001 and 1002.  They do not include any substantive changes in tax law.

 

 

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