The first major American tax overhaul since 1986, the Tax Cuts and Jobs Act (TCJA) of 2017 has arrived. Congress has approved it, and now the bill will be sent to President Trump to be signed into law, expected before Christmas.
What does the largest overhaul of the tax code in a generation mean to you, and how does it affect your planning? While this is a highly complex and voluminous law, read on for first impressions!
Changes to the Income Tax Brackets
Under the new law, the individual tax brackets are set at 10%, 12%, 22%, 24%, 32%, 35% and 37%.
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What this means for your planning: You and your advisers should quickly review what marginal bracket you will be in for 2017 vs 2018. This may impact the advisability of deferring income or accelerating deductions, depending on which year will provide the greatest benefit.
Personal Exemptions and Standard Deductions
The new law eliminates deductions for personal exemptions while increasing standard deductions to $12,000 for single filers and $24,000 for married, joint filers. The following, well-known itemized deductions are being modified or eliminated:
- The deduction for state and local income, sales and property taxes is capped at $10,000.
- The deduction for mortgage interest is reduced, and only allowable on up to $750,000 of acquisition indebtedness (note that mortgages incurred on or before Dec. 15, 2017, are grandfathered in and thus still allowed $1 million of acquisition indebtedness).
- The home equity loan interest deduction is repealed.
- Taxpayers will be allowed to deduct medical expenses if they exceed 7.5% of adjusted gross income (instead of 10%) for tax years 2017 and 2018.
What this means for your planning: Be mindful of how the loss of personal exemptions affect your taxable income. For those of you who are used to deducting sizable state and local income taxes, work with your advisers to determine if accelerating the payment of state and local property taxes makes sense.
Those no longer allowed to deduct state income taxes should speak to their advisers about alternative solutions to avoid or mitigate state income taxes.
If possible, you may wish to accelerate medical expenses into 2017 and 2018 to take advantage of the lower 7.5% of AGI limitation.
Charitable Income Tax Deductions
The new law increases the charitable contribution limit to 60% of AGI for cash contributions (up from 50% now), while keeping the limit on contributions of appreciated property at 30% of AGI.
What this means for your planning: If you will no longer itemize, you may wish to consider a contribution to a donor advised fund before the end of the year where you can make a charitable contribution and receive an immediate tax benefit.
Individual Alternative Minimum Tax (AMT)
The AMT exemption is increased to $70,300 for single filers and $109,400 for married joint filers. The thresholds for the phase-out of the AMT exemptions are increased to $500,000 for single filers and $1 million for married joint filers.
What this means for your planning: Those of you with incentive stock options should consult with your advisers to time the exercise of these options in years they are not subject to AMT due to higher exemptions.
Estate Tax
TCJA does not repeal the estate tax as was proposed in the House version, however it doubles the estate, gift and GST tax exemption amounts from the original $5 million (which has grown to $5.49 million in 2017 and which will be $5.6 million in 2018, due to adjustments for inflation) to $10 million (which, when adjusted for inflation, is $10.98 million in 2017). The 2018 Unified Exemption – which is the gift and estate tax exemption combined, meaning if you use the exemption for gifting it will reduce the amount you can use for the estate tax -- will be $10.6 million per person. It’s double that per couple, and the surviving spouse may use any unused portion left over from the spouse first to die. It also provides for increases to the exemptions based on inflation. The exemption sunsets after 2025.
What this means for your planning: With the exemption set this high only a tiny fraction of families will be affected by estate taxes. However, for those that are affected, it is an enormous tax bite at 40%! This can easily destroy a closely held business or large family farm – and for those affected it will definitely undermine family legacy goals! This means planning is still critical for families with large, closely held businesses or those that have a net worth significantly greater than the exemption amounts.
Considering that, barring further congressional action, the exemption amounts will revert back to $5 million for individuals in 2026. So planning now while the gift tax exemption is doubled for the next several years may be crucial. Make sure to discuss these matters with your adviser!
Clients who purchased life insurance to finance the payment of estate and other taxes and expenses should think carefully before canceling or reducing coverage. If your estate does not now nor is ever likely to exceed the inflation-indexed exemption amount(s), using the new-found exemption amounts to “un-wind” life insurance premium financing and note sale transactions may be attractive. Making large gifts to irrevocable life insurance trusts (ILITs) that have dynastic provisions could also be worth exploring.
Estate tax planning is still required for those who live in states that have decoupled and instituted their own state estate tax. In many cases, the state exemption may be significantly lower than the federal amount.
Business Income Tax Changes
Unlike the changes affecting personal income tax, most of the changes affecting business income are permanent.
Corporate Income Taxes
The corporate income tax is reduced to 21%, down from 35%, and corporate alternative minimum tax is repealed.
What this means for your planning: Premiums on corporate-owned life insurance should be lower while death benefits received by a corporation from a life insurance policy it owns may be more effective. All arrangements involving corporate payment of life insurance premiums should be reviewed.
Pass-Through Businesses
TCJA provides for a 20% deduction on non-wage portions of pass-through income. In short and simply stated, if the pass-through income for a married couple is $315,000 or less ($157,500 for single filers), then the 20% deduction is limited to 50% of the W-2 wages, or in the case of a business that requires capital (a non-personal service business) 25% of W-2 wages plus 2.5% of the adjusted cost basis of the assets. Architects and engineers have been exempted from these limitations. Pass-through income exceeding the $315,000/$157,500 thresholds receives no 20% deduction.
In practice this means that pass-through businesses (partnerships, LLCs, S corporations, and sole proprietorships filing a Schedule C) will be effectively taxed on only 80% of their pass-through income – or, put another way, on only 80% of their normal rate on all business income!
What this means for your planning: Planners and business owners will need to revisit how a client’s business should be structured and operated and re-evaluate the pros and cons of pass-through entities in the light of the law dropping the C Corporation rate to 21% and changing the long-standing approach of taxing pass-through business income at individual tax rates. Numerical comparisons are essential!
You should talk to your adviser about finding the lowest tax bracket party to pay for needed life insurance, and about split dollar life insurance to remove equity out of a business while minimizing current income tax.
The step up in basis is retained so assets held in your taxable estate at death will receive a new stepped up tax basis. This is very valuable, especially in the high-tax states such as New York, California, Illinois and Hawaii, so make sure you do the math before moving your low basis appreciating assets out of your estates. Careful planning and flexible dynasty trusts, like the HYCET Trust, will be vitally important.
Other Tax Provisions
TCJA contains many other provisions. The following is a brief summary of some of them most relevant to most people:
- Full expensing of investments in new depreciable assets made after Sept. 27, 2017, and before Jan. 1, 2023, will be permitted.
- There is a 20% per year phase-down of the full expensing for property placed in service after Dec. 31, 2022, and before Jan. 1, 2027.
- The limit on section 179 deductions wherein businesses can deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year is increased to $1 million.
- Deductions for certain fringe benefits, such as business entertainment expenses, have been limited.
- Net operating loss (NOL) deductions are limited to 80% of pre-NOL taxable income. There is an indefinite NOL carryforward, but no carryback to prior years for most companies.
- A three-year holding period is required for a carried interest to qualify as a long-term capital asset.
- The itemized deduction for personal casualty losses would be restricted to losses incurred in a presidentially declared disaster area. This sunsets after 2025.
- Tax-preparation fees are no longer deductible. This sunsets after 2025.
- Except for members of the armed forces, moving expenses are no longer deductible. This sunsets after 2025.
- Reversing or re-characterizing a Roth IRA is no longer permitted.
- The penalty for failing to maintain minimum health care coverage is effectively eliminated starting Jan. 1, 2019.
- 529 Plans can be used for K-12 schools and for homeschooling.
- The alimony deduction for the payor ex-spouse and the inclusion of alimony in gross income of the recipient ex-spouse is repealed for any divorce or separation instrument executed or modified after Dec. 31, 2018.
Conclusion
We have just seen the first major tax change since 1986. It may be years before the broader ramifications of TCJA are known, but it is fairly certain to impact most all Americans.
Be that as it may, much remains to be seen. Will the new law result in meaningful higher wages, new jobs and business growth? Will it help middle or lower income Americans to any meaningful extent? Will it dangerously increase the deficit? Will it weaken social safety nets?
What is certain is that in the end whatever is done can be eventually undone when the political climate changes. Most of the provisions affecting individual, as opposed to corporate, taxpayers sunset after 2025, and if the other party is in power at that time, you can most predictably expect the lower tax provisions not to be extended. Accordingly it seems safe to say that none of this is will be “permanent,” as permanent fixes are never permanent so long as future Congresses can make changes. This is why executives, professionals, business owners, high-income and high-net-worth individuals and families will always benefit from planning advice and expertise to understand their options.