HIGHLIGHTS OF THE TAX CUTS AND JOBS ACT
The Tax Cuts and Jobs Act (the “Act”), signed into law on December 22, 2017, provides substantial (but mostly temporary) changes to the tax code. This article is a summarized review and discussion of the key provisions of the new law. This article is designed to provide an introduction to the law and to supply some information to you (the taxpayer) before meeting with your attorney, tax advisor, investment manager and insurance agent for recommendations and before changing or implementing any financial, tax, or estate planning changes.
The Act provides changes to the tax code beginning January 1, 2018 (with a few provisions beginning in 2019). Although the Act does not directly affect your 2017 filings, some taxpayers were able to pay a portion of their 2018 residential real estate taxes in 2017 (enabling an additional deduction for those taxes paid for that tax year as long as the taxes had been assessed before the end of 2017).
The law is mostly temporary with the exception of a few provisions – the corporate tax rate reduction to 21% was made permanent. The individual tax provision (including the wealth transfers tax provisions) is set to automatically expire after 2025 and revert back to 2017 law.
- Individual Taxes:
For income tax purposes, taxpayers calculate their taxable income based on their gross income minus adjustments, their standard or itemized deductions and their personal exemptions. The federal government taxes that figure at a progressive tax rate to determine the total amount of tax the taxpayer owes (which can later be reduced through tax credits). For tax years 2018-2025 the Standard Deduction has been doubled. Many itemized deductions have been lost. It appears that for a New York taxpayer the amount of local income and property tax, the type of income (wages versus “qualified business income”), and mortgage interest will be among the most important factors to determine whether the taxpayer is paying more or less tax under the Act.
The Act keeps seven tax brackets but with different rates and break points. Individual Tax Rates are as follows: 10% (same), 12% (lowered from 15%), 22% (lowered from 25%), 24% (lowered from 28%), 32% (lowered from 33%), 35% (same), 37% (lowered from 39.6%).
The Standard Deduction has nearly doubled to $24,000 for couples and $12,000 for individuals. This means many taxpayers will not itemize their deductions. The Personal Exemption of $4,050 has been eliminated. Itemized Deductions have significant changes, including the following:
- The phase out of the itemized deduction has been removed.
- Home mortgage interest can be deducted on up to $750,000 of new acquisition debt on a primary and/or second residence. Existing mortgages are grandfathered in at $1,000,000. Home Equity loans are no longer deductible.
- Deductions for State and local tax (SALT) have been paired way back. The maximum deduction now available for residential real estate taxes, income taxes and/or sales tax, combined, is $10,000. This is one of the few provisions not indexed for inflation. It is also important to note that single individuals are entitled to $10,000 and married couples are limited to $10,000, so two single taxpayers with the same facts as a married taxpayer could face a lower tax liability as they would each be able to deduct $10,000 instead of the $10,000 cap for married taxpayers.
- The medical deduction is enhanced, temporarily. The adjusted gross income threshold has been lowered from 10% to 7.5% for 2017 and 2018.
The Child/Dependent Tax Credit is doubled to $2,000 for each child (subject to a higher phase out). The Kiddie Tax has been simplified so that unearned income of children under the age of 18 is taxed at the ordinary income and capital gains rates applicable to trusts and estates (not at their parents’ marginal tax rate).
Generally, retirement savings plans have not changed. 529 college savings plans are upgraded to allow annual distributions of up to $10,000 per student to pay tuition for elementary and secondary education.
The law keeps, but modifies, the Alternative Minimum Tax (AMT). AMT imposes a minimum tax on the amount of your taxable income above a designated exemption. The Act raises the AMT exemptions to $109,400 (married) and $70,300 (others) and raises the phase out of exemptions beginning at $1 million for married taxpayers and $500,000 for others.
Other Individual Provisions:
- Roth recharacterization is no longer allowed. Taxpayers can no longer recharacterize a Roth conversion.
- Taxation of Alimony (beginning in 2019). Alimony and separate maintenance payments are made non-deductible to the payor spouse and non-taxable to the receiving spouse.
- Like-kind exchanges. The Act limits like-kind exchanges to real estate only.
- Beginning tax year 2019 Obamacare’s individual mandate has been repealed (requirement that taxpayer has health insurance, qualify for an exemption, or pay a fine).
- The adjusted gross income limitation on cash donations to qualified charities is increased from 50% to 60%. There is some concern that, without itemized deductions and the increase in the estate/gift tax exemption, the financial incentive to donate to charities will be lessened.
- Deductions for job-related moves (except for the military) have been eliminated. All miscellaneous write-offs subject to 2% of your adjusted gross income (AGI) threshold, including employee business expenses, brokerage and IRA fees, hobby expenses, tax return preparation costs and home office deduction have been eliminated.
- Business Income:
Corporate (C corporations) income tax rate is permanently lowered to 21% beginning in 2018.
A new temporary deduction for pass through companies is contained in the Act, which expires December 31, 2025. Individuals, trusts and estates are allowed to deduct 20% of qualified business income (QBI) received from a pass through company (an S corporation, LLC, partnership, and sole proprietorship). The approach here is to provide small businesses relief by permitting a non-itemized deduction of 20% of qualified business income (the reduced income would then be subject to normal marginal tax rates). Many questions remain about the details of how the deduction for pass-through entities will apply. Generally, as drafted, this deduction is allowed against business profits and does not apply to wages earned by the business owner for services. The Act provides that if your taxable income is less than the “threshold amount” for the year, then you can simply deduct 20% of the QBI. The “threshold amounts” for 2018 are adjusted gross income below $315,000 if married and filing jointly, or $157,500, if single. The taxpayer determines taxable income without factoring in any potential 20% deduction.
If a taxpayer exceeds these threshold amounts, this new provision becomes significantly more complicated.
- In a non-service industry, the amount of the deduction, if you are above the threshold, is the lesser of 20% of QBI or the greater of 50% of wages paid by the business or 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property.
- For businesses that provide services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, investment or brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees, excluding architectural and engineering services, the deduction is phased out until the taxpayer reaches the income of $415,000, married, and $207,500, single, at which point there is no deduction available.
QBI specifically excludes investment income such as long term capital gains, dividends, interest income (other than when properly allocable to the trade or business), and amounts received under an annuity contract, guaranteed payments and W-2 income. Taxpayers are able to deduct 20% of income received as qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.
Given these significant changes, your current business entity choice may no longer be the best choice for tax purposes. Business owners may need to evaluate whether it is beneficial to segregate favored and unfavored business activities into different entities given the uncertainty of the deduction after 2025.
III. Wealth Transfer Taxes (Estate and Gift Tax):
Under the past and current federal wealth transfer tax laws you can gift or devise assets up to a certain value tax-free. Once the value exceeds that “applicable exemption” the assets are then taxed. The Act doubles the base federal estate, gift and generation-skipping tax exemption amount to $10 million, indexed for inflation, for tax years 2018 through 2025. For 2018, that exclusion amount will be close to $11,200,000 per person. The Act extends the already limited reach of the federal estate, gift and GST taxes to even a smaller subset of taxpayers. The exclusion amount is slated to revert back to $5 million adjusted for inflation after December 31, 2025 (the exclusion for 2017 was $5,490,000 and it was set to increase to $5,600,000 for 2018 under the prior tax law).
The step-up in basis at death continues unchanged.
The current New York State applicable exemption for estate tax purposes is $5,250,000 and is scheduled to increase on January 1, 2019 to an estimated $5,600,000.
Wills and other testamentary documents (especially those drafted prior to 2012) should be reviewed. The provisions related to the funding of credit shelter trusts and other marital trusts may need to be updated so that they contain the flexibility to adjust for changes to the tax law while ensuring they accurately reflect your wishes.
Charitable planning should be reviewed if the planning was intended to lower or avoid estate tax. Such planning may not have the same effect during the 2018-2025 period. Lifetime gifts to charities may be a better option.
All factors must be considered when planning to take advantage of the current law. Contact your tax and legal advisor to determine how the Act impacts you and your business.