The Tax Cuts and Jobs Act of 2017
Now What Do We Do?
By David A. Ison
The new tax law recently signed by Congress has important consequences for your tax liabilities. No one should underestimate the challenges and the opportunities implicit in the new law. But, big change can also bring favorable circumstances.
My goal in writing this article is to identify the issues that impact you the most. Issues like estate planning, asset protection, business structure, planning, and choice of entity.
This is not an in-depth article that covers all the topics in the tax Act. I strive for brevity with the intent to explore more in subsequent articles. I urge you to read this. There’s a lot at stake. The sooner you understand the way the new law affects you, the sooner you can take advantage of its benefits.
New Tax Act Requires New Thinking
There’s no question about it, the new law will challenge our old way of thinking. But, it also gives you an opportunity to modify existing personal and business structures to take advantage of new tax regimes.
Our legal team continues to examine the nuances of the law. We’re participating in continuing education programs such as the 2018 Heckerling Institute on Estate Planning, which is comprised of top tax experts.
We’ll continue to study the voluminous reports and analysis that describe tax and structuring techniques. With that new information, we’ll work with you to modify your existing financial and tax structure, and create new ones to your advantage.
We should be careful to avoid knee jerk reactions and bandwagon approaches to the changed tax landscape. We’ll only recommend changes after careful thought.
This is a time when all your advisors need to work together in unison. This includes your financial advisors, legal counsel, wealth advisors, and your accounting team.
The New Tax Law Isn’t Permanent
Most of the tax act will expire after 2025. But before then, it could be heavily modified if politics take a turn in another direction. But, because there’s a deadline on some of the provisions, we should quickly and seriously examine where it makes sense to implement immediate changes to your finances and tax liabilities.
The Easy Ones First
One of the easiest changes is doubling the unified gift and estate tax exemption amount. The effect of that change is that the 2018 exclusion is just over $11 million per person. It’s marked for increase each year.
You might consider taking the entire exemption before the law changes and reduces the exemption by fifty percent. The service might not claw back gifts made under current law. The annual gift exclusion for 2018 is $15,000 per person per donee.
Less than one percent of estates need traditional estate tax planning. So, be sure to examine your estate plan to see if it still uses outdated credit shelter fractional share techniques. The new paradigm for estate planning focuses attention on distribution, directed trusts, discretion, asset protection, and methods to increase basis.
Personal Income Tax Consequences
For personal income tax, the standard deduction increases to $24,000 for married individuals. The personal exemption is eliminated. The net result of these two changes will produce a modest tax savings for some taxpayers.
For instance, under pre-Act law, a married couple’s 2018 standard deduction would have been $13,000, and the personal exemption would have been $4,150. Combined, the couple’s deduction and exemptions would have been $13,000 + 4,150 + 4,150, or $21,300.
If the couple had two children the deduction would have increased to $29,600 by adding two more personal exemptions. But not all news is bad for parents. The Act doubles the Child Tax Credit from $1,000 to $2,000 per child. This credit makes up for the loss of exemptions.
Because the Act increased standard deduction and eliminated or limited many individual deductions, many taxpayers will use the standard deduction. They will no longer realize any income tax benefits from charitable contributions, home mortgage interest payments, state and local tax payments, or other payments still qualifying as deductions for those who qualify to itemize deductions. It might be advisable to congregate these deductions and take them in a single year, which would allow itemizing deductions rather than using the standard deductions that year.
If you qualify to itemize deductions, charitable contributions are deductible. Cash contributions limitations increased from 50% to 60% of the “contribution base” – usually a modified AGI. College sports fans suffered when the Act eliminated the 80% deduction for contributions made for university athletic seating rights.
Mortgage Deductions Are Reduced
If you qualify to itemize deductions, you may lose some of your mortgage interest deduction. The Act decreased the home mortgage interest for acquisition indebtedness of a residence incurred after December 15, 2017 from $1 million to $750,000. That $750,000 is not indexed and is a hard limit. For home mortgage indebtedness incurred prior to December 15, 2017 and refinancing of those loans not exceeding the refinanced indebtedness, the pre-Act rules apply. From 2018 through 2025, no deduction is allowed for interest on home equity indebtedness regardless when it was incurred.
No More SALT Deductions
You also will lose deduction for state and local income, sales, and property taxes, often called “SALT”, for amounts over (i) $10,000 (not indexed) for joint filers and unmarried individuals; and (ii) $5,000 (not indexed) for a married individual filing a separate return. This SALT limitation prompted many states to consider legislation to provide relief under state taxation. Some commentators optimistically predicted the SALT limitations are so unpopular that Congress will “fix it.” With the two parties at odds over every issue, I am not optimistic they can fix anything.
One way to relieve the SALT limitation burden, is owning residences by various trusts for various beneficiaries, each of which would have its own $10,000 limitation for the property tax deduction. The SALT $10,000 limitation does not apply to taxes paid “in carrying on a trade or business or an activity described in section 212” (i.e., investment activities). The limitation should not apply to state and local taxes reported on Schedule C (for a trade or business) or Schedule E (net income from rents and royalties). The SALT limitations would not apply to other business entities carrying on a trade or business or investment activity, including those involved in owning and renting real estate. When planning be aware of other Code sections that aggregate trusts and entities whose primary purpose is to avoid paying income tax.
New Rules For Alimony, Education, Roth IRA, Life Insurance
The Act declared alimony payments will not be deductible and will not be income to the recipient. The Act also repealed section 682 of the Code related to grantor trust status and taxation of trust income between former spouses. The alimony and repeal of 682 provisions are effective for any divorce or separation instrument executed after December 31, 2018 and any divorce or separation instrument executed before that date if a subsequent modification expressly states the Act applies. This provision does not sunset but will remain the law until changed by Congress.
The Act changed 529 Plans. For distributions after 2017, “qualified higher education expenses” will include tuition at public, private, or religious elementary or secondary schools, limited to $10,000 per student during any taxable year.
The Act prohibits recharacterization of a Roth IRA for conversions to a traditional IRA effective for taxable years beginning after 2017. This provision does not sunset after 2025. Prior to the Act, a Roth IRA that received a contribution or that resulted from a conversion of a traditional IRA could have been recharacterized as a traditional IRA before the due date for the individual’s income tax return for that taxable year. Contributions to Roth IRAs are still permitted.
As we live longer, life settlements of life insurance policies have become more popular. The Act reversed the IRS position on the taxpayer’s basis in a life insurance policy. The taxpayer’s basis is not reduced by the “cost of insurance” charges. Reporting requirements are added for “reportable policy sales,” and none of the transfer for value exceptions apply to life settlements. These provisions do not sunset after 2025.
The Act also eliminates miscellaneous deductions but allows medical expense deductions if you qualify to itemize. Moving expenses deductions, except those incurred by military, are eliminated.
“C” & “S” Corporation Status
A much discussed area is the new 21% flat tax rate for corporations taxed as traditional “C” corporations. For many years, the possibility of double taxation for owners of “C” corporations caused many advisors to recommend business owners utilize “S” status or partnership status for their ownership structure. That structure may no longer be the rule of thumb, or it may be only part of the solution.
To balance the tax burden, the new law allows pass through entities, like “S” corporations, partnerships, and sole proprietorships a Qualified Business Income Deduction of 20% of Qualified Business Income. Taxpayers who qualify including trusts and estates may use this deduction. The business income must be from a trade or business and not investment income to qualify for the deduction.
The 20% deduction reduces taxable income, but not AGI. The deduction does not affect limitations throughout the Code based on AGI. The deduction is available to both itemizers and non-itemizers. It is available in addition to the standard deduction.
199A? It’s Complicated.
The 199A deduction is complicated. When considering the loss, reduction, or elimination of itemized deductions and excluding certain high earning tax payers, a critical analysis of each business structure is appropriate.
Businesses should be analyzed according to their specific trade or business aspects and potentially restructured into separate trade or businesses with ownership structures to take most advantage of 199A, the reduced “C” flat tax, and other beneficial ownership structure.
These are some of the 199A provisions which have generated attention:
● The deduction has a wage limitation. The deduction is limited to: (i) 50% of W-2 wages, or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition, of all tangible property subject to depreciation. The latter limitation, described by some as the “real estate exemption”, could be very beneficial to real estate companies. These limitations may lead to using a common paymaster and similar structures where a management company serves as a common paymaster for separate entities and allocates the proportion of W-2 wages used by each entity.
● The deduction has a specified service business limitation. Certain businesses are excluded from using the deduction. The deduction does not apply for specified service businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees. Engineering and architecture is excluded from the list and still may qualify for the deduction.
● The 20% deduction is further limited to owners who meet certain income restrictions. The deduction is phased out with higher income. The wage limitation and the specified service limitation do not apply if the taxpayer has taxable income below a threshold amount of $315,000 for married individuals filing jointly and $157,500 for other taxpayers. The deduction is phased out for taxpayers over the next $100,000/50,000 of taxable income. These amounts are indexed to increase.
Other Areas Affected By Tax Bill: Income & Expenses
● The Act modified the Kiddy Tax. The earned income of a child is still taxed under the child’s single individual rates. Under the Act, a child’s unearned income over $2,100 is taxed at the ordinary and capital gains rates applicable to trusts and estates, which often are higher than the parents’ rates.
● The Act increased taxpayer expense deductions of the cost of depreciable tangible personal property and certain real property purchased for use in a trade or business to $1 million reduced by the cost of qualifying property placed in service during the year over $2.5 million. The balance of the cost is depreciated over an applicable period of years.
● The Act increased the additional first year depreciation deduction to 100% expensing for qualified property acquired and placed in service after September 27, 2017 and before 2023, or 2024 for certain property, and extends expensing to used and new property, with certain phase outs.
● Interest deductions for businesses with average annual gross receipts over $25 million for the three prior years generally are limited to 30% of the corporation’s adjusted taxable income computed without regard to depreciation, amortization, or depletion deductions, or in later years the 199A deduction. Disallowed interest can be carried forward indefinitely.
● The corporate alternative minimum tax is repealed. The repeal removes one of the disadvantages of corporate owned life insurance to fund an entity-purchase buy sell agreement.
● Like-kind exchanges are permitted for real property held for use in a trade or business or for investment. The Act eliminated the like-kind treatment for personal property.
● No deduction will be allowed for expenses of a trade or business related to entertainment, amusement, or recreation activities or for membership dues to any club organized for business, pleasure, recreation, or other social purposes. The 50% limitation on deductions continues to apply for meals associated with operating the trade or business.
● Net operating losses (NOLs) are deductible only up to 80% (down from 100%) of taxable income (determined without regard to the deduction). NOLs can no longer be carried back to prior years. Indefinite carryforwards will continue to be allowed.
● Employees who receive stock options or restricted stock for performing services may defer recognition of income for up to five years upon exercise of the options (or earlier when the qualified stock becomes transferable or readily tradable on an established securities market). One percent owners, executives, and their family members are disqualified from the special deferral provision.
● A three-year holding period will apply for certain partnership interests received in the performance of services to be taxed as long-term capital gain.
● A sale of 50% or more of the capital and profits of a partnership will no longer result in a technical termination of the partnership.
Altering a business structure, implementing new trusts, and optimizing taxpayer personal and business affairs to the new tax reality won’t happen on its own. You should promptly review your financial and tax status with your professional team of advisors. Relying on old rules or ignoring this monumental change in taxation could result in unnecessary taxes and expense.
We are available now to answer your questions about the tax reform Act and how it impacts your personal and business structure. Please feel welcome to contact us today!
© 2018 David A. Ison
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