RIA Washington Watch: Tax reform moves to the front burner

Key Points

  • In the wake of multiple failed efforts to pass health care reform, Congress has now turned its attention to tax reform. Gain insight into the legislative steps ahead and a potential timeline for tax reform’s journey from framework to law. Plus, find out where the fiduciary rule saga stands now, and get a glimpse into the regulatory issues that lie ahead.

RIA Washington Watch is an ongoing series featuring the observations, insights, and analysis of Michael Townsend, vice president of legislative and regulatory affairs for Charles Schwab & Co., Inc., regarding issues and topics that affect Registered Investment Advisors (RIAs), their clients, and the RIA industry.

Republicans set their sights on tax reform

After eight months with few legislative accomplishments, Congress began September by quickly passing a bipartisan bill that provides emergency aid to victims of Hurricanes Harvey and Irma, averts a government shutdown until December, and pushes the fight over raising the debt ceiling into 2018. The battle over health care legislation reform was paused after failing to pass, yet again, in the Senate. Those developments have cleared the decks for a major push on tax reform this fall.

On September 28, Republican leaders in Washington released their much-anticipated “unified framework” for tax reform. The document offers the most detailed account yet of how Republicans would like to overhaul the tax code, but many questions remain unanswered.

Key elements of the plan:

  • Reduces the current seven individual tax brackets down to three: 12%, 25%, and 35%. The plan leaves wiggle room for a fourth rate for the highest earners, but that decision is up to Congress. Recent reports suggest that leaving the top rate at 39.6% is still on the table.
  • Roughly doubles the standard deduction to $12,000 for individuals and $24,000 for couples.
  • Eliminates the alternative minimum tax.
  • Eliminates the estate tax.
  • Reduces the current top corporate tax rate from 35% to 20%.
  • Caps the tax rate applied to certain so-called “pass through” entities—such as sole proprietorships, partnerships, and S corporations—at 25%, though uncertainty remains about which types of small businesses would qualify for this treatment.

Up in the air: Where do deductions, credits, and incentives fall?

Beyond the uncertainty around the highest individual tax rate, the framework document leaves several other key questions unanswered for advisors and investors.

What happens to the thousands of tax credits and deductions in the tax code?
The plan says only that it “eliminates most itemized deductions, but retains tax incentives for home mortgage interest and charitable contributions.” How credits and deductions are handled will likely be one of the most controversial elements. Virtually every credit and deduction has a constituency that wants to preserve it.

How will investment income be taxed?
The plan is silent on tax rates for dividend income and capital gains. It also makes no mention of the fate of the Net Investment Income Tax, the 3.8% surtax on investment income for wealthier taxpayers as part of the Affordable Care Act.

Will there be changes to retirement savings incentives?
The framework says only that it “retains tax benefits that encourage work, higher education and retirement security.” But reports in Washington suggest that changes may be coming to retirement savings incentives, including the idea that some or all contributions might be taxed up front, as with Roth accounts.

How will the bill be paid for?
The framework calls for an estimated $5 trillion in tax cuts, which would blow an enormous hole in the federal budget and dramatically increase the federal deficit. At least some tax cuts would need to be offset with provisions that raise revenue for the Treasury, but the plan is vague on those details. Trade-offs likely will create winners and losers and could be fiercely debated.

Mapping the road to tax reform

The unveiling of the framework is the first step in a long and arduous legislative process that could take many months.

From framework to bill – The questions above must be answered as negotiators turn a few pages of general principles into a massive legislative proposal. The Senate Finance Committee and the House Ways and Means Committee (committees of jurisdiction) will go through each section of the bill, simultaneously changing it as they see fit. This means two very different bills could come to a vote on the Senate and House floors.

Budget reconciliation, a key hurdle – Both chambers of Congress must pass a budget reconciliation bill containing instructions for special procedural rules in the Senate. With a slim Republican Senate majority, it is believed that limiting debate, restricting amendments, and prohibiting a filibuster may be the only chance for Senate approval.

Conference committee – After two versions of tax reform legislation pass, the two chambers of Congress must form a conference committee to negotiate the details and create a single piece of legislation for presidential approval.

This process will likely take months and feature many stops, starts, and unexpected detours. And there’s no guarantee that Republicans will unify around a single plan. The party has spent many months trying unsuccessfully to pass health care reform legislation, and tax reform is at least as complex as health care.

In terms of timing, we expect legislation will be introduced sometime in mid- to late October, with committees in both chambers working through the bill in November.

That time frame could leave lawmakers confronting another significant obstacle: The current agreement to keep the government open and operating expires on December 8. At some point in November, Congress will need to focus on passing an extension of government funding in order to avert a possible shutdown on December 9.

This makes it doubtful that Congress will be able to pass a tax reform bill into law by the end of 2017. A more realistic expectation is that this issue will be the top priority for Congress in early 2018, because Republicans will want to get a signature accomplishment on the books as they head into the midterm elections next fall.

Fiduciary rule: Ask again later

On the regulatory front, the Department of Labor’s (DOL) fiduciary rule continues to dominate headlines. On August 31, the DOL proposed an 18-month delay in the fiduciary rule’s final compliance deadline, signaling that potentially significant changes to the rule could be in the works.

The rule, which redefines who is a fiduciary and curbs conflicts of interest in the retirement savings space, was finalized last year. The first part of the rule went into effect in June, but significant portions of the rule—including new disclosure requirements and the launch of the Best Interest Contract Exemption governing interactions between advisors and investors—were scheduled to take effect on January 1, 2018. The delay would push the final compliance deadline to July 1, 2019. A decision on the delay is expected in October.

Meanwhile, the DOL is conducting an economic analysis of the rule’s impact following an executive memorandum from President Donald Trump earlier this year. The study should be completed by the end of the year. That analysis could trigger revisions or even a full-scale rewrite of the regulation. The DOL indicated that it may roll back certain provisions, including the mandatory arbitration waiver, which allows customers to use class-action lawsuits for breaches of fiduciary duty. The department stated that it will not enforce the provision while the review is ongoing. Some reports indicate the DOL may use the delay to alter or eliminate the Best Interest Contract Exemption.

Ongoing debate over the fiduciary rule has passed the seven-year mark—an example of how little in Washington is ever really final. While Congressional Republicans are energized in their desire to construct a legislative solution on the investment advice issue, sharp partisan divisions make this approach a long shot. To muddy the crystal ball even further, DOL Secretary Alexander Acosta and U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton publicly vowed to increase their agencies’ levels of coordination on the issue, possibly including a new SEC rulemaking effort on the fiduciary standard.

Regulatory roundup

Cybersecurity in the headlines. September saw the announcements of two disturbing cybersecurity incidents: the massive hack at credit reporting agency Equifax that may have exposed the personal information of more than 140 million Americans and the disclosure of a hack into the SEC’s public company information database. The two incidents immediately became fodder for a series of Congressional hearings, at which lawmakers called for new steps to be taken in the fight against cyber thieves. Cybersecurity has already been a top concern of investment advisors and a central focus of advisor exams by regulators. Expect the Equifax and SEC data breaches to keep the heat on for the foreseeable future, and don’t be surprised to see new legislative or regulatory cybersecurity requirements coming down the road.

Are you helping prevent elder fraud?

The North American Securities Administrators Association found that most state securities regulators believe that broker-dealers and investment advisors do not do enough to prevent financial fraud against seniors. All advisors should stay vigilant on this critically important issue.

Elder financial abuse continues to be a top concern. Regulators at the federal and state levels are increasingly focused on financial scams that target the elderly. (Anyone 65 and older or an adult with a physical or mental impairment that renders them unable to protect their own interests is defined as an “elder” by FINRA.) Both the SEC and the Consumer Financial Protection Bureau are ramping up education and enforcement efforts. Effective February 2018, a new FINRA rule will permit broker-dealers to put a temporary hold on the disbursement of funds if there is a reasonable belief of financial exploitation. On Capitol Hill, the Senior$afe Act, which nearly passed Congress in 2016, has been reintroduced and could move forward later this year. The bill aims to protect investment advisors and other financial professionals from liability for reporting suspected financial abuse of the elderly, provided the professional has received training in how to spot possible exploitation.

This report is current as of October 20, 2017 Advisor Services™ is committed to keeping you abreast of the latest happenings in Washington. Look for future RIA Washington Watch updates from Michael Townsend.