The Tax Cuts and Jobs Act (the “Act”) was signed into law by President Trump on December 22, 2017. The Act amended various provisions of the Internal Revenue Code of 1986, as amended (“Code”), most of which are effective starting in 2018. One of the goals of the reform was to simplify the tax system. Proponents of the Act even suggested that it would result in most Americans filing their taxes on a postcard. While some parts of the Code were indeed simplified, others were made more complicated, particularly the provisions relating to businesses. Moreover, many of the provisions are scheduled to expire in 2026. So, don’t count on receiving that postcard any time soon.
Individuals, Trusts & Estates
The Act maintained seven tax brackets, but with substantial changes. The brackets are now 10%, 12%, 22%, 24%, 32%, 35% and 37%, compared to 10%, 15%, 25%, 28%, 33%, 35% and 39.6% under prior law. The new top bracket of 37% kicks in for single taxpayers at $500,001 and at $600,001 for married filing jointly (“MFJ”). Before the Act, the top brackets were scheduled to start at $426,701 and $480,051, respectively. Trusts and estates saw a reduction from five to four brackets – 10%, 24%, 35% and 37%, rather than 15%, 25%, 28%, 33% and 39.6%. The top bracket still applies at a very low threshold, $12,500. Before the Act, the threshold was scheduled to be slightly higher, $12,700.
The “kiddie tax” rules have also changed. The rules prevent parents in high tax brackets from shifting income to children in lower brackets. Under prior law, if a parent was in a higher bracket than a child, the child’s unearned income (generally, passive investment income) over $2,100 was taxed at the parent’s highest marginal tax rate. Now, the child’s unearned income over $2,100 will be taxed at the rates for trusts and estates.
Deductions, Exemptions and Credits
The Act increased the standard deduction from what would have been $6,500 for single taxpayers ($13,000 for MFJ) to $12,000 ($24,000 for MFJ). This may lead to a significant increase in the percentage of taxpayers who use the standard deduction, rather than itemizing their deductions. However, the personal exemption, which was scheduled to be $4,150 in 2018 per each taxpayer, spouse and dependent, was eliminated. The combination of the foregoing changes may result in tax savings for single taxpayers and small families but will likely result in a tax increase for larger families. Trusts and estates will continue to receive a deduction in lieu of a personal exemption ($600 for estates; $300 for “simple” trusts and $100 for “complex” trusts).
The child tax credit has gone up from $1,000 to $2,000 per qualifying child under age 17. The credit is increased by $500 for each dependent who is not a qualifying child. The phase-out of the credit, which, under prior law, started at adjusted gross income (“AGI”) of $75,000 ($110,000 for MFJ), now does not begin until $200,000 ($400,000 for MFJ). Previously, the credit was potentially refundable (it could not only reduce the tax due, but could result in, or add to, a refund) for taxpayers with earned income of at least $3,000. Under the Act, the refundable portion is limited to $1,400 (subject to future inflation adjustments), and the earned income threshold has been decreased to $2,500 (not indexed for inflation).
Charitable contributions continue to be deductible (for those who itemize deductions), and the limit for deducting cash contributions was increased from 50% to 60% of the taxpayer’s “contribution base” (AGI without regard to any net operating loss carryback).
The home mortgage interest deduction will now be limited to interest on up to $750,000 of acquisition indebtedness – debts incurred in acquiring, constructing or substantially improving the taxpayer’s primary residence (and one other residence) – after December 15, 2017. The prior limit of $1,000,000 will still apply to acquisition indebtedness incurred on or before December 15, 2017, and to any future refinancing up to the old debt. The Act eliminates the deduction for interest on home equity indebtedness (other than indebtedness used to buy, build, or substantially improve the taxpayer’s home), regardless when incurred. However, the limitations apply only to personal interest and, therefore, are not applicable to rental properties.
The deduction for state and local income, sales and domestic property taxes (other than those related to business or investment activities) will now be limited to $10,000. The limitation may result in a significant tax increase for residents of high income tax states. This has led some to speculate that there will be a mass exodus to Florida, which does not impose a state income tax; however, others believe that talk of an exodus is overblown.
For individuals, the new law repeals all miscellaneous itemized deductions (“MIDS”), including those from pass-through entities, that are subject to the 2% floor. Typical deductions included appraisals, tax advice and preparation fees, income production expenses, deposit losses from insolvent financial institutions, and investment management and financial consulting fees. The deductions for unreimbursed employee deductions for travel, meals and entertainment, union dues, home office, job legal fees, malpractice and liability insurance premiums, professional dues and journal subscriptions, work uniforms, licenses, tools and supplies are also repealed.
Generally, under prior law, the total amount of itemized deductions was reduced by 3% of AGI over a certain threshold amount. This “Pease” limitation on itemized deductions has been repealed.
Since trusts and estates compute taxable income in the same manner as individuals, expenses for the MIDS mentioned above will be disallowed. However, it is less clear if expenses paid in connection with the administration of the estate or trust, which would not have been incurred if the property were not held in such trust or estate, are deductible. New Code Section 67(g) provides MIDS are not allowed “notwithstanding Code Section 67(a),” without reference to Code Section 67(e). Personal representative and trustee fees are not considered MIDS. To be deductible, it may be necessary to determine the expense’s underlying purpose as being either related to income and investment producing activities, therefore non-deductible, or a fiduciary fee that is potentially deductible.
When terminating an estate or trust by distributing all assets, the beneficiaries are allowed to use the deductions in excess of gross income for the year of termination on their individual income tax returns. However, any excess deductions considered MIDS for an individual’s tax return are no longer deductible.
The Act temporarily expands the deduction for medical expenses. For 2017 and 2018, taxpayers will be permitted to deduct medical expenses in excess of 7.5% of their AGI; in 2019, the floor for the deduction will revert back to 10% of AGI.
For divorce and separation agreements executed after December 31, 2018, alimony payments will no longer be deductible by the payor or includible in the income of the recipient. This incentivizes completing such agreements before 2019 and is likely to affect post-2018 settlement negotiations.
Alternative Minimum Tax
The alternative minimum tax (“AMT”) regime is retained with exemptions and phase-outs significantly increased. The exemption for single taxpayers increased from $55,400 to $70,300 (from $86,200 to $109,400 for MFJ), and the phase-out increased to $500,000 ($1,000,000 for MFJ).
The corporate AMT regime has been repealed. Any current AMT credit being carried forward to future years may generally be utilized to the extent of the taxpayer’s regular tax liability.
Retirement and Other Planning
Individuals are allowed to “convert” all or part of a traditional IRA to a Roth IRA, with a need to declare the converted amount as income, subject to taxes. If the converted amount decreased in value before the due date of the individual’s tax return, with extension, the taxpayer could reverse the conversion. After December 31, 2017, a conversion from a traditional IRA, SEP, or SIMPLE to a Roth IRA cannot be recharacterized. However, a Roth IRA conversion made in 2017 may be recharacterized as a contribution to the traditional IRA if done by October 15, 2018.
For Section 529 plans, under pre-Act law, income and withdrawals were tax-free if used for qualified higher education expenses. The Act allows a tax-free aggregate withdrawal of $10,000 per student each year when used to pay expenses to the expanded class of public, private, and religious elementary and secondary schools. The dollar limitation does not apply when the withdrawals are used for post-secondary school expenses.
The individual shared responsibility payment imposed by the Affordable Care Act’s mandate that people obtain minimal essential health insurance has been reduced to zero, effective after 2018.
Estate, Gift and GST tax
The Act doubled the exclusions for estate, gift and generation-skipping transfer (GST) taxes from $5 million to $10 million, indexed for inflation starting in 2011. Inflation adjustments under the Act (for a variety of thresholds, not just for the estate, gift and GST tax exclusions) are to be calculated using a new measure, referred to as the “Chained CPI,” which is slightly less generous than its predecessor. At the time the authors submitted this article, it was estimated that the Chained CPI would yield an exclusion of $11.18 million, but that amount had not yet been confirmed by the Internal Revenue Service. The exclusion is per individual and, therefore, a married couple would enjoy twice the exclusion or $22.36 million.
The doubling of the exclusions is one of the tax breaks that is scheduled to expire in 2026. Accordingly, wealthy individuals may be inclined to utilize the super-sized exclusions by making gifts to family members, or to trusts for their benefit, before the exclusions decrease. Some have expressed concern that, under such circumstances, there could be a “clawback” – that a gift utilizing the increased exclusion would later be subject to estate tax if, at the time of the taxpayer’s death, the exclusion is lower. However, the Act directs the Secretary of Treasury to prescribe such regulations as may be necessary or appropriate to address the issue, and it is anticipated the regulations will eliminate any possibility of a clawback.
The huge increase in the estate tax exclusion and its potential reversion to a lower amount in 2026 should lead taxpayers to rely even more heavily on portability. The portability rules, which became effective in 2011, permit the unused estate tax exclusion of a deceased spouse to “port” (i.e., transfer) to a surviving spouse. Thus, if one spouse dies between January 1, 2018 and December 31, 2025, the unused portion of the decedent’s beefed-up $11.18 million exclusion could be utilized by the surviving spouse, even if the exclusion reverts back to $5 million (adjusted for inflation) by the time the surviving spouse dies. But, portability is not automatic; the estate of the deceased spouse must file a federal estate tax return, Form 706, to make a portability election. Moreover, it is recommended that estate planning documents contemplate the possibility of a portability election and include enough flexibility to take advantage of the ported exclusion.
The estate tax exclusion doubled only for the estates of U.S. citizens and residents. The Act was silent on the exclusion for non citizen, non-residents; accordingly, such individuals still receive an estate tax exclusion of only $60,000 (unless modified by a tax treaty). The Act also did not specifically address the annual gift tax exclusions, but the Chained CPI will now govern inflation adjustments to those exclusions as well. Subject to confirmation by the Service, it is estimated that the annual exclusions for 2018 will be $152,000 for gifts to non-citizen spouses (up from $149,000 in 2017) and $15,000 for gifts to each other donee (up from $14,000 in 2017).
Beginning in 2018, to make the U.S. corporate tax rate more competitive with rates imposed by foreign countries, the progressive tax structure has been replaced with a flat tax. The maximum tax rate for C corporations has been lowered from 35% to 21%. When applying the 21% rate, the new law does not tax investment income differently from business income.
Under pre-Act law, net operating losses (“NOLs”) were fully deductible, and could be carried back for 2 prior years and carried forward for 20 years. The new law limits post-2017 NOL deductions to 80% of taxable income, and provides that they can only be carried forward indefinitely.
The rules regarding carried interest, which can be earned by investment fund principals and certain other industries, allow for partnership interests received in connection with the performance of services to be taxed as capital gain income. Now, for long term capital gain treatment, there is a new 3-year holding period required, regardless of whether a Code Section 83(b) election was made.
The law added new Code Section 199A, a complicated provision that dramatically affects the taxation of pass-through businesses including entities taxed as partnerships, S corporations, Schedule E rental activity income, and Schedule C entities. A deduction to taxable income of up to 20% of qualified income depends on the business activity and the taxpayer owner’s total income. The income must be effectively-connected with a U.S. trade or business. The qualified business income (“QBI”) deduction applies whether the taxpayer is active or passive in the business activity. The QBI deduction does not reduce basis. Calculation of the QBI deduction is done on an entity basis, not in the aggregate. The multistep process to determine the actual QBI deduction amount begins with dividing owners into three groups based simply on their overall taxable income.
Single individuals with less than $157,500 ($315,000 for MFJ) of total taxable income may claim a 20% QBI deduction on their pass-through income (“PTI”). For this low income threshold group, the type of business activity is immaterial.
The second income group, singles that have total taxable income between $157,500 and $207,500 (between $315,000 and $415,000 for MFJ), may claim a partial QBI deduction regardless of the type of business activity, but the QBI deduction phases out for a specified service business (“SSB”). SSB’s include law, accounting, medical, consulting, financial, athletic, performing arts, brokerage, investment, actuarial, and where the principal asset is the reputation or skill of the employees.
The SSB phase-out is on a pro rata basis until total taxable income reaches $207,500 ($415,000 for MFJ). Here, the SSB phase-out is based on the amount by which the taxpayer’s total taxable income exceeds the $157,500 ($315,000 for MFJ) threshold divided by $50,000 ($100,000 for MFJ).
The third income threshold group, singles with more than $207,500 ($415,000 for MFJ) of total taxable income, may not claim a QBI deduction if their PTI is derived from a SSB. However, if the PTI is from any other type of business, then the QBI deduction will be limited based on a wage and qualified property test.
When the taxpayer’s total taxable income exceeds $157,500 ($315,000 for MFJ), the deduction may be limited by the amount of wages paid and the qualified property the business uses. This overall deduction limitation is based on the lesser of (1) 20% of the entity’s QBI or (2) the greater of (A) 50% of the W-2 wages paid to all employees or (B) the sum of (i) 25% of W-2 wages plus (ii) 2.5% of the unadjusted basis of all business “qualified property.” Wages are defined to include those paid to all employees during the calendar year ending during such taxable year. Qualified tangible property is subject to a depreciable period under Code Sections 167 and 168 which is used for business income production and held at the tax year end. In this context, depreciable period may be different than a property’s depreciable life for purposes of a business tax deduction. In accord, tangible property that has been fully depreciated for tax purposes (i.e., by using bonus or accelerated conventions) can still be counted for Code Section 199A if within the depreciable period.
The QBI deduction does not reduce the taxpayer’s income subject to the self-employment tax. A pass-through taxable loss that is carried forward to future years may cause a reduction in the QBI deduction amount. Estates and trusts holding a qualified business may be able to take the QBI deduction.
The new law lowers the dividends received deduction (“DRD”) from 20% owned corporations from 80% to 65%. The 70% DRD from less than 20% owned corporations is reduced to 50%.
The Code Section 179 expensing election’s maximum deductible amount is increased to $1,000,000, reduced by the cost of property placed in service during the year that exceeds $2,500,000. The balance of the asset’s cost is depreciated over the applicable period. Bonus depreciation has been increased to 100% for property acquired and placed in service between 2018 and 2023. Qualified property now includes used property acquired by purchase if the acquiring taxpayer had not previously used the acquired property and it was not acquired from a related party.
Under previous law, personal property and real estate qualified for tax-deferred like-kind exchanges. However, the new law limits the tax-deferral regime to real property held for investment or for use in a trade or business. Like kind exchange treatment is not allowed for exchanges of real estate held primarily for sale. Real property located within the U.S. is not considered like-kind to real property located without the U.S.
Pre-Act law allowed businesses to deduct expenses associated with entertainment and amusement activities, including club membership dues. The Act repeals the deduction of these types of expenses. However, the 50% deduction for food and beverage expenses directly related to the taxpayer’s trade or business is retained. In addition, there is a new 50% limitation to the deduction for meals associated with operating the business, such as an on-premises cafeteria provided to employees. Previously, businesses could deduct 100% of the meal expense.
Sunset After 2025
Although the business provisions of the Act are permanent (unless and until Congress votes to change them), most of the provisions of the Act pertaining to individuals expire in 2026. Without the “sunset” of these provisions in 2026, the Act would not have satisfied the Senate’s “Byrd rule,” which allowed the Act to pass with only a simple majority of votes. The Senate passed the Act by a party-line vote of 51 to 48. (Senator McCain was absent.)
Under the rules, tax reform was authorized only to the extent it would produce no more than $1.5 trillion of deficits over ten years. It has been estimated that making the Act’s provisions permanent would yield a deficit of $2.7 trillion over ten years. Therefore, don’t plan on the provisions being extended into 2026 and beyond.
The Act has far reaching ramifications that will impact taxpayers for many years. Although simplifying the tax system may have been the goal, the end result is more complexity. Tax professionals are going to need some additional rest and relaxation after digesting all the new rules. Maybe that’s what Congress was thinking when they included provisions in the Act to reduce taxes on beer and wine for the next two years.