Tax Reform & Year-End Planning Advice
December 22, 2017
Earlier today, President Trump signed into law the largest tax reform bill in over 30 years, entitled the “Tax Cuts and Jobs Act” (the “Act”). This memorandum provides a summary of those provisions of the Act that we believe will have the broadest impact on our clients. This is not a comprehensive summary, so if you have specific questions about particular provisions of the Act, please contact us for a more detailed explanation.
This memorandum also mentions several items that were not changed under the Act. In recent weeks, news outlets have inundated the public with reports of potential changes, some of which would have been significant. We thought it important to highlight some of these proposed changes that did not take effect under the Act so that you can continue to plan under current law.
Finally, the last section of this memorandum lists several suggestions and planning opportunities to minimize your overall tax burden as we head into 2018.
I. Individual Tax Reform
All of the provisions impacting individuals, except as otherwise noted, are temporary. They apply for tax years beginning after December 31, 2017 and before January 1, 2026. For calendar year taxpayers, that means these provisions will be in effect from 2018 through 2025.
Marginal Tax Brackets
The current brackets include the following rates: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. There are four categories of taxpayers: single, head of household, married filing jointly, and married filing separately.
Under the Act, the same four categories will remain, but the marginal brackets will change to the following rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
The standard deduction for 2018 under former law would have been $6,500 for single filers and married individuals filing separately, $9,500 for heads of household, and $13,000 for married individuals filing jointly.
Under the Act, the standard deduction is increased to $12,000; $18,000; and $24,000, respectively, and will be adjusted for inflation beginning in 2019. The biggest impact of this increased deduction amount is that taxpayers who formerly itemized their deductions may no longer need to do so. This may negate the tax value of charitable contributions, so one of our tips is to fulfill any charitable pledges you have made this year while itemizing will still be beneficial.
Taxpayers were formerly allowed to subtract a personal exemption amount ($4,050 in 2017 and what would have been $4,150 in 2018) from adjusted gross income as part of the determination of taxable income. Under the Act, the personal exemption has been reduced to $0, effectively eliminating it.
Measure of Inflation
For those amounts that are subject to annual adjustment to account for inflation (such as the standard deduction), the Act changes the measure of inflation to a “chained” measure. Under a “chained” measure, inflation grows at a slower pace; thus, we expect the annual inflation-adjusted increases to be lower than in the past.
Under former law, the net unearned income of a child was taxed at the parents’ rates (if the parents’ rate was higher). Under the Act, such net unearned income will be taxed according to the brackets for estates and trusts, which includes a top marginal rate of 37% for income exceeding $12,500.
Capital Gains Rates
The Act generally retains the current maximum rates on net capital gains of 0%, 15%, and 20%, as well as the breakpoints for when those rates are triggered. However, the breakpoints are adjusted for inflation in 2018 under the “chained” method.
Under former law, the standard 20% profits interest referred to as the partner’s “carried” interest was taxed at favorable capital gains rates instead of as ordinary income. Under the Act, IRC § 1061 has been amended to provide that a 3-year holding period is imposed if capital gain treatment is to be afforded.
Child Tax Credit
The Act increases the child tax credit from $1,000 to $2,000. The income level phase-out has been increased substantially to $400,000 for joint filers and $200,000 for all other filers. The Act also makes the credit refundable for up to $1,400 per qualifying child (and that amount will be increased in future years for inflation, up to the base credit amount of $2,000).
State and Local Tax Deductions
The Act distinguishes between (i) individuals, and (ii) taxpayers carrying on a trade or business under IRC § 162 or who are engaged in an activity for the production of income under IRC § 212.
For individuals who are not carrying on a trade or business or are not engaged in an activity for the production of income, foreign real property taxes cannot be deducted at all. Additionally, the overall deduction for (i) state and local real property taxes; (ii) state and local personal property taxes; and (iii) state, local, and foreign income taxes (or state and local sales tax in lieu of state and local income tax) cannot exceed $10,000 (or $5,000 for married filing separately).
However, for those taxpayers who are carrying on a trade or business or who are engaged in an activity for the production of income, the $10,000 cap on the deduction does not apply to (i) state, local, or foreign real property tax; (ii) state and local personal property tax; or (iii) foreign income tax. But the $10,000 cap does still apply to state and local income tax (and presumably also to state and local sales tax if claimed in lieu of state and local income tax).
Mortgage Interest Deduction
Under former law, mortgage interest on a “qualified residence,” which included both a principal/primary residence and one other property, could be deducted as an itemized deduction. The underlying mortgage loan could represent acquisition indebtedness (a loan used to purchase the primary or other residence) of up to $1 million, as well as home equity indebtedness of up to $100,000.
Under the Act, interest paid on home equity indebtedness is no longer deductible. And the deduction for mortgage interest is limited to loans of $750,000 or less (or $375,000 for married filing separately). The Act does not change the definition of “qualified residence,” so it appears that mortgage interest can still be deducted, subject to the reduction in the underlying loan amounts, on both a primary residence and another property.
There are special rules for acquisition indebtedness incurred before December 15, 2017 and for taxpayers who entered into a binding purchase contract before that date. If you fall into one of these categories, please contact us for more details.
There are also special rules for taxpayers who are interested in refinancing current mortgage loans. The former $1 million for mortgage loans still applies, as long as the debt that is being refinanced was incurred before December 15, 2017.
Medical Expense Deduction
Under former law, the deduction was allowed for total unreimbursed medical expenses that exceeded 10% of the taxpayer’s adjusted gross income (or 7.5% if the taxpayer had reached age 65). Under the Act, but only for tax years 2017 and 2018, the threshold amount is reduced to 7.5% of adjusted gross income, and this reduced amount applies to all taxpayers regardless of age.
Charitable Contribution Deduction
Under current law, the amount of the deduction was limited to certain percentages of the taxpayer’s “contribution base,” depending on the type of property contributed (e.g., cash vs. in-kind property) and the identity of the recipient (e.g., there is a distinction between a public charity and a private foundation).
Under the Act, the 50% limitation for cash contributions to public charities and certain private foundations is increased from 50% to 60% of the donor’s “contribution base.” Contributions exceeding that limit may still be carried forward for 5 years.
While the charitable deduction still exists as an itemized deduction, if your calculations indicate you will no longer be itemizing (because the amount of the standard deduction is higher), we encourage you to maximize your charitable deductions this year while they still retain tax value.
Deduction for College Athletic Seating Rights
Current law, under IRC § 170(l), allows 80% of an amount paid to an institution of higher education in exchange for the right to purchase tickets or seating at an athletic event to be deducted.
Under the Act, this deduction is eliminated. Thus, if you are a college booster or a college season ticket holder, and you intend to remain a season ticket holder for future years, you should consider paying the season ticket price before the end of the year.
Under current law, alimony payments made by a former spouse were deductible under IRC § 215 and were included in the gross income of the recipient spouse under IRC § 71.
Under the Act, for any divorce agreement executed after December 31, 2018 (one year from now), alimony will no longer be deductible by the paying spouse or included in the gross income of the recipient spouse.
Miscellaneous Itemized Deductions
Under current law, certain miscellaneous itemized deductions could be claimed if they exceeded, in the aggregate, 2% of the taxpayer’s adjusted gross income. These deductions included expenses incurred for such things as tax preparation expenses and investment advisory fees.
Under the Act, this deduction has been suspended.
Repeal of Obamacare Individual Mandate
Under current law, taxpayers without minimum essential health insurance coverage paid a penalty. Under the Act, the penalty is effectively eliminated by a reduction to $0. This is a permanent change.
However, the 3.8% net investment income tax under IRC § 1411 and the 0.9% additional Medicare tax under IRC § 1401 remain in effect.
Alternate Minimum Tax (AMT)
The AMT remains intact for individuals. The calculations required to compute this tax are complex and should be further discussed with us or your accountant if you have AMT concerns.
Expanded Use of 529 Accounts
Under current law, a § 529 Account could be used only for “qualified higher education expenses” at “eligible schools,” which included generally only colleges, universities, or vocational schools. There was a 10% penalty on the earnings portion of each withdrawal
Under the Act, “qualified higher education expenses” now include tuition at elementary or secondary schools, including public, private, or religious schools. Certain expenses associated with home schooling are also qualified. Thus, there is less of a likelihood that a withdrawal would need to be made for a non-qualified purpose.
Retirement Plan Conversions
Current law allows an individual who has converted a traditional IRA to a Roth IRA to “re-characterize” the Roth IRA as a traditional IRA, as long as the re-characterization occurs before the due date of the individual’s income tax return for that tax year. People do this when the account value of the Roth IRA drops after the conversion from the traditional, because the value of the “after tax” dollars is decreasing.
The Act no longer allows re-characterizations of Roth conversion contributions. Thus, beginning in 2018, once a traditional IRA has been converted to a Roth IRA, the conversion can no longer be unwound.
II. Estate, Gift, and Generation Skipping Transfer (GST) Tax Reform
Under current law, each person has a unified credit against gift and estate tax that allows them to make gifts during life (including lifetime transfers into irrevocable trusts) and to pass property at death up to the “basic exclusion amount,” which is $5,490,000 per person (or $10,980,000 for a married couple). In 2018, these amounts were set to increase for inflation to $5,600,000 per person (or $11,200,000 for a married couple).
Under the Act, from 2018 through 2025, the basic exclusion amount doubles. Thus, individuals will now be able to make gifts or die with property of $11,200,000 per person (or $22,400,000 for a married couple) without incurring gift or estate tax. Transfers that exceed these amounts will continue to be taxed at a top rate of 40%.
The Act does not mention the GST tax, but because the GST tax is also subject to an exemption amount that equals the “basic exclusion amount,” the GST tax exemption amount will also double to $11,200,000 per person. Unlike the estate tax exemption, though, the GST tax exemption is not portable (i.e., the decedent’s unused amount cannot be used by his or her surviving spouse).
Like many of the other tax reform measures discussed above that affect individual taxpayers, the doubling of the basic exclusion amount is set to expire at the end of 2025 (if a change in Congressional party control does not result in these amendments being undone at some earlier time). Under the Act, starting in 2026, the basic exclusion amount will return to current levels.
III. Corporate Tax Reform
Tax Rate Reduction
Under current law, corporations are taxed at graduated rates of 15%, 25%, 34%, and 35%.
Under the Act, corporations are now subject to a flat tax rate of 21%.
Dividends Received Deduction
Under current law, corporations that receive dividends from other corporations are entitled to a deduction of 70% of the amount of the dividend received. And if the receiving corporation owns at least 20% of the corporation paying the dividend, the deduction is increased to 80%.
The Act reduces the 70% and 80% deductions, respectively, to 50% and 65%.
Alternative Minimum Tax (AMT)
Beginning in 2018, the Act repeals the corporate AMT.
Section 179 Expensing
Under current law, a taxpayer may elect to immediately deduct (i.e., “expense”) the cost of “qualifying property” rather than recover the cost of such property over a series of years through depreciation deductions. For 2017, the maximum amount that can be expensed is $510,000 of qualifying property that was placed in service in that tax year, and this amount is reduced by the amount that the cost of the “qualifying property” exceeded $2,030,000.
Under the Act, the maximum amount that can be expenses increased to $1 million and the phase-out also increased to $2.5 million and will be further indexed for inflation.
Bonus Expensing under § 168(k)
Under current law, in addition to § 179 expensing, a taxpayer could take advantage of additional bonus expensing under § 168(k) in the first year that “qualified property” was placed in service, by claiming an additional deduction of 50% of the adjusted basis of the qualified property.
Under the Act, the first year bonus deduction is increased to 100% of the adjusted basis of the qualified property placed in service after September 27, 2017 and before January 1, 2023. For years 2023 through 2026, the 100% first year bonus deduction is phased down and will sunset beginning in 2027.
Corporate Interest Deduction
Under current law, interest paid by a business is generally deductible in computing its taxable income, subject to certain limitations. The Act now disallows all businesses, regardless of their form, from claiming a deduction for the net interest expense in excess of 30% of the business’s adjusted taxable income. For pass-through entities, this disallowance is determined at the entity level, not the partner or shareholder level.
However, there is an exemption from the disallowance that applies to taxpayers with average annual gross receipts for the three preceding years not in excess of $25 million.
Modification of the Net Operating Loss (NOL) Deduction
Current law allows NOLs to be carried back 2 years and carried forward 20 years to offset taxable income in such years.
Under the Act, the 2-year carryback provision is repealed (except for farming businesses and property and casualty insurance companies). Additionally, the NOL deduction is limited to 80% of taxable income, as determined without regard to the NOL (except for property and casualty insurance companies, which can offset 100% of taxable income). But NOL carryovers can now be carried forward indefinitely.
Like-Kind Exchanges under § 1031
Current law allows taxpayers to defer the recognition of gain on the exchange of property used in a trade or business or held for investment purposes for like-kind property. The law applied to a wide range of property, including real estate and personal property.
Under the Act, beginning in 2018, § 1031 treatment is allowed only for real property that is not held primarily for sale. However, a transitional rule allows current law to apply to exchanges of personal property if the taxpayer has either disposed of the relinquished property or acquired the replacement property before the end of 2017.
Employer Deduction for Fringe Benefits
Currently, a taxpayer may deduct up to 50% of expenses related to meals and entertainment. The Act disallows the deduction for entertainment expenses (but not meals), thereby eliminating the subjective determination of whether such entertainment expenses were sufficiently business related. The Act also disallows employers a deduction for employee transportation fringe benefits, such as parking and mass transit. Employees may still exclude the value of such benefits from being included in their gross income.
Deduction for Local Lobbying Expenses
Current law disallows a deduction for lobbying and political expenditures with respect to legislation and candidates for office, except for lobbying expenses incurred with respect to legislation before a local government (i.e., local government lobbying expenses are deductible).
Under the Act, this deduction is also eliminated.
Credit for Employer-Paid Family and Medical Leave
Currently, no credit is allowed to employers who pay compensation to employees while on leave. The Act creates such a credit for tax years 2018 and 2019 so that businesses can claim a general business credit of 12.5% of the amount of wages paid to qualifying employees during any period when such employees are on family or medical leave (FMLA), as long as the rate of payment to such employees is at least 50% of their normal wages. The 12.5% credit increases by 0.25% (up to a maximum of 25%) for each 1% above 50% that the wage rate is increased.
Thus, for example, if an employer paid an employee on FMLA 60% of his or her normal wage rate, the credit would increase from 12.5% to 16.5% (the 4% increase is equal to the 10% wage increase x 0.25%).
IV. Taxation of Pass-Through Entities
For all entities that are taxed as pass-through entities (such as “S” corporations, partnerships, and LLC’s that are taxed as partnerships or that have an “S” election in place), the Act drastically changes the way the individual shareholders, partners, or members calculate their reportable income.
Under current law, the net income of pass-through entities is not subject to an entity-level tax, and the income flows through to the individual shareholders or partners, who then report their share of such income on their own individual tax returns. This procedure made the entity’s income effectively subject to the individual’s income tax rate.
The Act adds a very complex § 199A to the Tax Code, entitled “Qualified Business Income.” Under this new section, non-corporate taxpayers (meaning individuals, but also including estates and trusts) who have “qualified business income” (QBI) from a pass-through entity are allowed to deduct a certain sum that is computed pursuant to a complex calculation but which is generally supposed to approximate 20% of the QBI. This deduction comes into effect for tax years beginning in 2018 through 2025.
QBI is generally defined as the net amount of qualified items of income, gain, deduction, and loss of the pass-through entity. It does not include reasonable compensation paid to a taxpayer who draws a salary from the entity (i.e., the W-2 wage portion earned by a shareholder of an “S” corporation who is also an employee) or to guaranteed payments to partners under § 707(c) or payments under § 707(a) to partners for services rendered to the partnership. It also does not include capital gains of the business that are passed through to the shareholders or partners.
The deduction permitted under this new § 199A is not an above-the-line deduction that can be taken when computing the individual’s adjusted gross income. Rather, it is allowed as a deduction in reducing the individual shareholder or partner’s QBI portion of his or her taxable income.
There is also a cap on the amount of the deduction, such that the deduction cannot exceed the greater of (i) 50% of the W-2 wages paid with respect to the trade or business or (ii) the sum of 25% of the W-2 wages paid with respect to the trade or business plus 2.5% of the unadjusted basis of all “qualified property,” which is defined as tangible, depreciable property held by the trade or business and used in the production of QBI and for which the depreciable period has not ended (which depreciable period shall be at least 10 years).
Subject to certain income limitations (there is a phase-out beginning at $157,500 for single filers and $315,000 for joint filers), this deduction does not apply to shareholders or partners of certain service businesses, including those businesses operating in the fields of health (medical or dental practices), law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. However, the fields of engineering, architecture, and businesses that involve the performance of services that consist of investment-type activities are not subject to this exclusion.
Those individuals who do practice in one of the excluded fields listed above may nevertheless be able to claim the deduction depending on certain taxable income limits.
This cap on the deduction amount was newly added in the joint conference committee and appears to have the effect of allowing individuals involved in real estate-based businesses to claim the deduction.
There are currently several unresolved questions that appear to exist as a result of this new statute, but we hope to gain more clarity in short order as we continue to dissect the various provisions. If you have questions of your own, we encourage you to contact us to discuss them.
V. Proposals that Were Not Enacted
The following items were proposed in some form or fashion but were never included in the final version of the Act and will not be enacted.
Student Loan Interest: The House had proposed to repeal the deduction for student loan interest, but the final bill has no repeal.
Dependent Care Accounts: At one point, the House had proposed to eliminate workplace dependent care savings accounts that allow employees to contribute $5,000 free of income taxes each year. It later altered the provision to have the accounts disappear in 2023. The Senate never proposed any change, and there is no change in the final bill.
Tuition Waivers: Employees of educational institutions who receive either a tuition reduction or waiver are generally not taxed on that income. The House had proposed to tax the benefit, but the final bill does not have this provision.
The § 121 Exclusion from Capital Gains When Selling a Home: A married couple filing their taxes jointly can exclude up to $500,000 in capital gains on the sale of a home, as long as they have used it as a primary residence for at least 2 of the last 5 years. A single individual can exclude up to $250,000. The House and Senate both proposed to lengthen the required residence period to 5 of the last 8 years, but neither provision prevailed, and the rule will remain the same.
401(k) Contribution Limits: Before the House and Senate introduced their bills, there were rumors they might try to restrict the amount of pretax money that people could contribute to their workplace savings accounts. They did not try to do this, though, and the rules for these accounts remain the same. An employee can contribute a maximum of $18,000 of his or her own funds (and employees age 50 and over can make additional catch-up contributions of $6,000), and an overall maximum, including any contributions made by the employer on the employee’s behalf, cannot exceed $54,000. In 2018, these amounts will increase to $18,500 (with the same additional $6,000 catch-up) and an overall maximum of $55,000.
Stock Sales (required “FIFO”) Method: Under current law, people who have shares of stock or funds in a taxable investment account can choose which shares to sell if they are selling part of their investment. This allows people who bought shares at different times to sell only the ones that will help them pay the least amount in taxes on any gains. The Senate proposed to restrict such moves by requiring a “first-in, first-out” (or FIFO) method, which in many cases would have had the effect of causing lower basis investments to be sold first, resulting in higher capital gain, but this provision did not make it to the final bill. Thus, you can still choose which shares you want to sell.
VI. Suggestions and Recommendations for Year-End Planning
Many of the old adages still apply. As a general rule, it is preferable to defer income. If you can delay receipt of a year-end bonus to next year, try to do so. If you own your own business, you may be able to control when you are compensated.
Conversely, it is preferable to accelerate deductions. If your tax rate will decrease in 2018, claim as many deductions as you can this year to minimize your 2017 tax burden. This is especially true if you do not think you will itemize your deductions as a result of the increased standard deduction.
One of the ways you can accelerate your deductions is to satisfy charitable pledges this year. Alternatively, you could contribute a large amount of money to a donor advised fund this year and retain direction over multiple future years as to which charities that money should be paid to. You will still reap the benefit of the charitable deduction for this year, but keep in mind that there is a 50% “contribution base” limit for the amount of the deduction that can be claimed this year. For those of you who are college sporting season ticket holders, consider paying next year’s booster commitment this year before the benefit is eliminated.
Another way to accelerate deductions is to pay your annual property tax bill this year instead of waiting until next year, especially if you do not think you will itemize deductions next year due to the increased standard deduction amount. In Florida, you will also receive a bigger discount on the base amount of the bill by doing so.
The same would be true for your regular mortgage payments. The portion of the payment allocable to interest would be deductible this year. It may also be wise to pay off (or at least pay down) home equity loans/lines of credit, because the mortgage interest deduction for such loans will no longer be available next year.
If you are considering any § 1031 exchanges for personal property, consider completing them by year’s end.
Because the FIFO method for stock sales was not enacted, you can still harvest your losses to offset any capital gains you may have recognized.
The new tax reform bill was passed very quickly and without much, if any, public commentary or vetting by tax professionals. It is very likely to contain holes and raise questions that simply do not have answers at the current time. It is a very lengthy bill, and this memorandum by no means is all encompassing. There are changes to many of the international tax laws that we have decided not to address at all in this summary.
We understand that you will have questions about the content of this memorandum, as well as about the reform bill generally. Please know that we are here to assist you in navigating these new provisions, and we encourage you to contact us with your questions.
Happy Holidays from your Johnson Pope tax attorneys!
Very truly yours,
Clearwater Tampa St. Petersburg
Bruce H. Bokor Vit M. Gulbis Joel D. Bronstein
Michael G. Little Jeffrey M. Gad Holger D. Gleim
Peter A. Rivellini Susan W. Carlson
Nicholas J. Grimaudo Thomas D. Sims
Melodie M. Menzer
Philip Nodhturft, III