By: Ronald Hegt
The Tax Cuts and Jobs Act of 2017 signed by President Trump in December is the largest tax reform to be enacted in several years. How the reform will affect you depends on, amongst other things, what kind of income you have, where you live, and the make-up of what historically have been your itemized deductions. This article will point out many of the significant changes and will highlight the pitfalls, gains, or unanswered questions that we all as taxpayers will face.
Tax rates were cut across the board and will, for 2018 through 2025, run from 10% to 37%. The impact of the full set of rate cuts should reduce taxes by approximately 3%, without giving any effect to other changes. This will to a large extent cut into the cost of many of the changes that reduced or eliminated deductions.
The preferential rates for long-term capital gains and qualified dividends remain unchanged but apply to a larger portion of income. While the highest tax rate payable on such income remains at 20% (without the additional 3.8% Net Investment Income tax), a married couple with taxable income of less than $77,200 will pay a zero tax rate on such income. The rate will increase to 15% to the extent taxable income is less than $479,000.
The elimination of personal exemptions and the scale back of many itemized deductions was intended to be offset by a near doubling of the standard deduction to $24,000 for a married couple. Whether this, in fact, is so depends on your mix of itemized deductions which were scaled back or eliminated. Highlights of the changed itemized deductions include the limiting of state and local income and real estate taxes to $10,000 per year and the elimination of all miscellaneous itemized deductions which include deductions for tax preparation fees, investment advisor fees, and employee business expenses. Deductions for mortgage interest have been scaled back for loans closed on or after December 15, 2017. These new loans will only carry deductible interest on the first $750,000 of principal, down from $1 million. Home equity loan interest for all loans will now only be deductible to the extent that funds were used to either purchase, construct, or improve a home.
The higher standard deduction, in addition to encouraging simplification, decreases the value of itemized deductions. Taxpayers should carefully watch timing of deductions, such as doubling up on charitable contributions and contributing every other year. This would allow the benefit of a larger standard deduction in a noncontributing year and higher itemized deductions in contributing years.
As a partial offset to the loss of personal exemptions, several changes have been made to benefit parents. The credit available for children under the age of 17 has been increased to $2,000. A credit of $500 per non-child dependent is also available. The benefit of these credits begins to phase out when a taxpayer’s joint adjusted gross income exceeds $400,000, up from $110,000 in 2017. In addition, a 529 plan can now be used to pay up to $10,000 per year in expenses at public or private elementary or secondary schools.
Much was made about the fact that the Alternative Minimum Tax for individuals was not repealed. However, since the two largest reasons for keeping AMT, deductions for state and local taxes and miscellaneous itemized deductions, are no longer an issue, far fewer taxpayers will be caught by it.
While every individual’s tax situation is different, a typical New York or Connecticut resident that has earned income of less than $3 million can expect to see their 2018 taxes decrease. Amounts will vary, but the impact of lower rates is offsetting the increase in income caused by deduction eliminations.
If you are the owner of, a partner in, or an S Corporation shareholder in a flow through business, you may be eligible for a deduction as high as 20% of your qualified business income. This could have the effect of reducing a maximum 37% tax rate to 29.6% on qualified income. Further limiting computations involving wages paid by qualifying businesses could cut this deduction down to zero.
A qualified business eligible for this deduction is any trade or business other than one involved in providing services in the fields of health, law, consulting, performing arts, athletics, finance, or brokerage. Architects and engineers should note that while they were initially included in the ineligible group, they were dropped off that list at the last minute as the bill made its way through Congress. While income from these businesses is not generally eligible for the 20% deduction, there is an exception that allows this “non-qualifying business income” to become eligible if a taxpayer’s taxable income is under $315,000.
While this could turn out to be one of the most beneficial provisions for individuals, it is fraught with unanswered questions and poorly defined terms. For example, is an insurance broker who really is selling insurance and keeping a commission a broker (who would not qualify for the deduction) or a commission salesperson (who would qualify)?
The centerpiece of tax reform is the reduction of the corporate tax rate to 21% from the current maximum rate of 35%. In addition, the corporate alternative minimum tax was repealed. At the same time, a change requiring immediate repatriation of earnings from foreign corporations (at preferential rates) was included in the reform as a revenue raiser and a precursor to moving the US foreign tax system to a territorial system in which income earned by foreign corporations owned by Americans will not be taxed going forward.
Numerous authors have suggested that the lowering of the corporate tax rate to a rate that is lower than the individual rate is the signal to convert partnerships and S Corporations to C Corporations. While there may be specific circumstances where this is advisable, in general the lower tax rate (21%) is offset by the fact that when the remaining earnings of the C Corporation are distributed and taxed as a dividend, the double taxation will create an almost 40% federal tax rate. This rate is higher than the maximum individual rate of 37% and certainly higher than the effective rate on qualified flow through business of 29.6%.
Many other business incentives were enacted as well. Depreciation rules have been changed to allow a 100% write-off of business property (other than real estate) acquired between September 27, 2017 and December 31, 2022. After that, the percentage declines until it reaches zero on December 31, 2026. In addition, Section 179 deductions, which are also a form of immediate write-off of business property, have been expanded to allow a maximum deduction of $1 million per year.
In the interest of expanding certain business benefits available to small taxpayers, the definition of a small taxpayer has been changed to one that has average annual gross receipts for the past three years of less than $25 million (up from $5 million). Once a company qualifies as a small business, they will be able to stay on (or convert to) cash basis of accounting and simplify their accounting for inventory.
In addition, a new restriction on the deductibility of business interest expense will limit the deductibility to 30% of taxable income computed before interest expense, net operating losses, and depreciation and amortization expenses. Beginning in 2022, the limitation becomes greater by not allowing depreciation and amortization to be added back in determining any limits. These restrictions do not apply to small taxpayers (see above), auto dealerships, or electing real property businesses.
In a bid to satisfy all involved, the estate tax has not been repealed. In place of repeal, the lifetime exclusion for estate, gift, and generation skipping taxes will double to $11.2 million per person. With the continued availability to transfer unused estate tax exemptions to a surviving spouse, a couple will be able to transfer in excess of $22.4 million of property free of estate tax. Based on 2016 filing data provided by the IRS, the remaining estate tax should only impact approximately 1,500 taxpayers per year. Keep in mind that this increased exemption is temporary and will revert back to $5 million in 2026, so the window for long-term planning is limited. Further complicating this is the fact that New York and CT have exemptions which are substantially lower than the new federal amount.
While many people will benefit from this law, there is much uncertainty regarding its implementation including poorly defined terms, potential legal challenges, varying effective dates, and sunsetting provisions which will revert many of the individual and estate tax changes back to pre-2018 law in 2026. A bigger, more current concern is how the states will deal with these changes. New York and Connecticut income tax rules require state computations to be based on federal income, as modified. We will all need to stay tuned to see what actions, if any, are taken by the states.
Ronald B. Hegt, CPA, is a tax partner at Citrin Cooperman with over 40 years of experience in accounting and taxation. He has managed corporate, partnership, and entrepreneurial high net worth individual engagements in both the tax planning and tax compliance arenas. Ron’s area of expertise is in serving as the entrepreneur tax and business adviser to middle market entrepreneurs, their businesses, and their families. He works extensively with partnerships, S corporations, estates, trusts, and ultra-high net worth individuals in tax compliance, as well as advises on business acquisitions, dispositions, and inter-generational transfers. He can be reached at 914.949.2990 or at email@example.com. Citrin Cooperman is a full-service accounting and consulting firm with 10 locations on the East Coast. Visit us at citrincooperman.com.