ANALYSIS AND COMMENTARY OF THE “TAX CUTS AND JOBS ACT” – 2017

On December 18, 2017, the House and Senate Republicans released their new tax package.  President Donald Trump signed it into law on December 22, 2017.  Contrary to main-stream media reporting, the package contains tax breaks for everyone.  The primary intent of these tax cuts is to stimulate the economy with the anticipation that the tax savings for both businesses and individuals will promote additional spending and, thus, generate positive economic results.  This theory is not new.  In 1981 when President Reagan became president, the highest marginal individual tax rate was 70%, there was runaway inflation, and the economy was worse than stagnant.  At that time, the Republican majority government passed tax laws reducing individual tax rates so that the top marginal tax rate was 50% as well as allowing expensing of certain large equipment purchases thereby reducing taxable income for businesses.  The spending of durable and non-durable items increased due to the lower taxes allowing higher take-home pay for workers.  Further, businesses began purchasing newer, more efficient equipment to replace out-dated or dilapidated older equipment.  This required manufacturers to begin higher rates of production to replace the inventory being purchased by consumers and, additionally, new jobs were created.  The economy soon began soaring, thus putting the original tax-cut theory into action.  The same thought process is the basis for the new tax laws.  Time will tell, but we think the same results will occur as did in the 80’s.

Most of the new tax law takes effect January 1, 2018 and expires December 31, 2025 and most tax rates, limits, and exemptions are adjusted annually for inflation.  There are some items that take effect January 1, 2017 (medical deduction phase out percentage limitation), and some items that take effect January 1, 2019 (repeal of the “Obamacare” penalty tax for individuals who do not have health insurance).

CORPORATE TAX HIGHLIGHTS

For tax years beginning after December 31, 2017, C-Corporation’s tax rates will be reduced from a high of 39% to a flat rate of 21%.  The theory behind this tax cut was two-fold: (1) lowering corporate tax brackets would free up corporate cash flow and allow more hiring and higher wages as well as purchasing new equipment to replace outdated equipment and (2) to bring the U.S. corporations into a more level tax field with foreign competitors, the idea being that U.S. corporations would now have disincentives to use foreign countries as “tax havens” for both employment and capital exportation.

Under old tax law, there were C-Corporation income tax rates ranging from a low of 15% to a high of 39%.  The lowest tax bracket was applied to taxable income for a C-Corporation between $0 and $50,000.  Therefore, under the old tax law, C-Corporations with taxable income of $50,000 or less would owe federal income tax of $7,500 or less.  Under the new tax law for tax years beginning after December 31, 2017, these small C-Corporations that earn taxable incomes of $50,000 or less are actually penalized because their income will now be taxed at 21% which, in the case of a C-Corporation who has taxable income of $50,000 will now pay $10,500 instead of $7,500, an increase of $3,000 in tax.

The corporate alternative minimum tax is now repealed for taxable years beginning after December 31, 2017.

BUSINESS-RELATED TAX HIGHLIGHTS

For years beginning after December 31, 2017, the deductibility of net operating losses carryovers will be limited to the lesser of the net operating loss carryover or 80% of taxable income computed without the net operating loss deduction.  In other words, the net operating loss carryover deduction will no longer be able to reduce taxable income to zero; the deduction will be limited to 80% of taxable income.  Additionally, there will no longer be a 2-year carryback option available.  Instead, any unused net operating loss will be available to be carried over to future years indefinitely (prior law limited the carryover period to 20 years).

ADS depreciation of residential rental properties placed in service after 2017 will be over 30 years (versus 40 years under old law) and commercial rental properties will continue to be depreciated over 40 years using the ADS depreciation method.

Depreciation expensing and Section 179 depreciation expense allowance has been expanded under the new tax law beginning for property placed in service after 2017.  Also, depreciation limits on automobiles used in business have been expanded allowing for greater depreciation for these types of vehicles.

Business interest expense is now limited for some taxpayers.  Business interest expenses is limited to the sum of (1) business interest income, (2) 30% of adjusted taxable income, and (3) the floor plan financing interest (car dealerships, mobile home retailers, etc.).  Business interest expense is defined as “any interest paid or accrued on indebtedness properly allocable to a trade or business”.  Business interest income is defined as “the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business.  Such term shall not include investment income”.  There is an exception: the business interest expense limitation will not apply to small businesses whose average gross receipts for the past 3 years does not exceed $5,000,000.  The limitation and exception applies to partnerships at the partnership level, not each individual partner and S-Corporations at the S-Corporation level, not each individual shareholder.

Like-kind exchanges will only be available for real property transactions completed after December 31, 2017 or the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017.  Prior law allowed for personal property used in a trade or business or for investment purposes to trade with another unrelated party for like-kind personal property, thus deferring any potential gain if that property were to be sold.  This new law could have a profound impact on business owners who trade in business-related vehicles for other vehicles through automobile dealerships because those trades may become taxable events (gain or loss).

Business entertainment will no longer be tax-deductible beginning in 2018.  Business meals will continue to be tax-deductible to the extent of 50% of the cost of the business meal and as long as proper substantiation is maintained by the taxpayer.  Business entertainment includes any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, including facilities costs used in connection with such an activity.

Transportation costs for employees that constitute (1) transportation in a commuter highway vehicle, (2) transit passes (ie, Sunpasses), and (3) parking costs will no longer be excludible from an employee’s gross income as a fringe benefit unless the transportation cost was directly related to business travel.  Business travel costs remain deductible as long as all the proper substantiation is maintained by the taxpayer.There is a new tax credit available for employers: Employer Credit for Paid Family and Medical Leave.  Basically, the credit is 12.5% up to 25% of the wages paid to an employee who takes a leave of absence for medical-related purposes such as, giving birth to a child and the aftercare of that child or caring for a spouse, child, or parent who has a serious health condition.  The determination of how much credit percentage is applicable depends upon the percentage of wages the employer pays the employee during their medical leave.  

The following table provides the applicable percentage available:

There must be a written policy in place in order for the credit to be available to any employer.  The plan must contain:

  • For any eligible full-time employee, the amount of leave is not to be less than 2 weeks nor more than 12 weeks,
  • For any eligible part-time employee, the amount of leave is prorated based on full-time comparison; ie, the number of hours per week worked by the part-time employee versus the number of hours worked by full-time employees,
  • The rate of pay for medical leave cannot be less than 50% of the rate of pay for normal services,
  • An eligible employee is one who:
    1. has been employed by the employer for at least 1 year,
    2. for the preceding year, had compensation that does not exceed 60% of the compensation referred to in Internal Revenue Code §414(q)(1)(B), as adjusted annually for inflation (for 2017 and 2018, this amount is $120,000) resulting in a limit of $72,000 for 2017 and 2018,
    3. Vacation pay, personal leave pay, and sick leave pay (other than medical leave under the policy) does not qualify for compensation under the policy
  • The policy is only in effect for the years 2018 and 2019.

 

NEW 20% REDUCTION OF BUSINESS INCOME

This deduction was written into the new tax law primarily (and maybe solely) because the top C-Corporation tax rate was reduced from 35% to 21%.  It was generally discussed that reducing only C-Corporation taxes would be unfair to all of the other small business owners who use other types of tax entities in which to run their businesses.  These entities would include sole proprietorships, partnerships, S-Corporations, and Limited Liability Companies (LLCs).  

Therefore, for regular tax purposes, the new tax law establishes Internal Revenue Code Section 199A which generally allows a 20% reduction of the taxable income for these types of entities, thereby being taxed on potentially only 80% of the otherwise taxable income from these trades or businesses.  Self-employment tax, if applicable, will still continue to be applied to the entire amount of taxable income from the trade or business.

The 20% deduction of qualified business income will be reduced or phased out based upon the taxpayer reaching and exceeding a threshold amount which is set at $157,500 for single, heads of households, and married filing separately taxpayers and $315,000 for married taxpayers filing a joint tax return.

The reduction and phase out computation involves a series of “what ifs” including the business owner’s salary from the business included on Form W-2 and the acquisition of tangible personal property used in the business.  If taxpayers do not exceed the threshold amounts of $157,500 (single/married filing separately/head of household) or $315,000 (married filing jointly), then the computation of the 20% deduction is much simpler.

The 20% deduction begins with taxable income of the taxpayer instead of the business taxable income because there are many other items that may comprise taxable income that has nothing to do with the actual business profits.  For instance, net capital gains will be backed out of taxable income because that type of income is taxed under a separate set of rules, most of which are advantageous to the taxpayer.  Therefore, the 20% deduction may not turn out to be a straight 20% reduction of a taxpayer’s trade or business net income for any given year.

Net qualified business losses will be carried over to succeeding years to be combined with any other qualified trade or business income in order to computer the allowable 20% deduction for that year (IRC §199A(c)(2)).

Generally, the term “qualified business income” means the net profit from a trade or business in the U.S. for any given year less any investment income items such as interest income, dividend income, capital gain income, or any amounts received from an annuity not in connection with the trade or business.

Additionally, personal service corporations or businesses (generally, those whose primary service is health, law, accounting, actuarial services, performing arts, consulting, athletics, and financial or brokerage services) will have their 20% deduction phased out with the same taxable income threshold amounts as discussed above ($157,500 for single/married filing separately/head of household taxpayers or $315,000 for married taxpayers filing jointly).  The deduction is completely phased out for single/married filing separately/head of household taxpayers at $207,500 of taxable income and for married taxpayers filing jointly if their taxable income exceeds $415,000.

Computation of the 20% deduction is done at the partner or shareholder level rather than at the partnership or S-Corporation level due to the wide variances of arriving at taxable income for all individuals.  The phase-out limitations noted above will be increased by the rate of inflation in years beginning after 2018.

The deduction for Domestic Production Activities is now repealed effective for taxable years beginning after December 31, 2017.

Partnerships will no longer be terminated if a partner owning 50% or more of the partnership sells or exchanges his or her partnership interest.  In the past, a partner might sell his 50% or more interest in a partnership (including death by that partner), and the partnership would technically be terminated.  This would require a new federal ID number as well as many other administrative adjustments.  The new tax law eliminates this part of the Internal Revenue Code so that if a 50% or more partner disposes of his interest during any given year, that partnership may continue its existence.

S-Corporation Conversion to C-Corporation As mentioned previously, the top C-Corporation tax rate will now be 21%.  Therefore, there may be some S-Corporation shareholders who deem it appropriate and equitable to convert their S-Corporation to C-Corporation for tax purposes.  When these conversions occur, there is inevitably various tax and accounting differences (also known as “481(a) Adjustments”) between the two types of corporations and these differences are required to be reported on the tax returns.  These differences are required to be reported ratably over a 3-year period.  However, if the corporation was an S-Corporation on December 21, 2017 and the S-Corporation converts to a C-Corporation by December 21, 2019 with the shareholders remaining the same, then the “481(a) Adjustment” would be required to be reported on the corporate tax return ratably over a 6-year period.

INDIVIDUAL TAX HIGHLIGHTS

Married couples filing a joint tax return will find that there is no longer a tax bracket “marriage penalty” until they reach the 35% tax bracket.  In the past, two single taxpayers each having a taxable income of $165,000 would have a tax liability of $37,181.75 each.  If they were to marry, then their combined taxable income would be $330,000 and one would assume that their tax liability would also double from $37,181.75 as a single taxpayer to $74,363.50 as a married couple.  However, the married couple’s tax liability would actually be $92,299.25.  The married couple is actually paying $17,935.75 more in income tax than two single individuals making the same amount of taxable income!  This is because the 2017 and prior married filing joint tax brackets are not actually double the single filer tax brackets.  That “marriage penalty” has been cured with this tax law up to the 35% tax bracket where the wealthiest married taxpayers will pay up to $8,000 more than two single wealthiest taxpayers once that married couple reaches $600,000 in taxable income.  

See old versus new tax brackets at the end of this document.

The individual alternative minimum tax is still in effect after 2017, but it will be more unlikely for this tax to have an impact on individuals due to the $10,000 limit on deducting property taxes as an itemized deduction and the elimination of miscellaneous itemized deductions (both of these items were considered “preference items” taken into account in computing alternative minimum tax.  Additionally, the income limits have been increased that would trigger the alternative minimum tax.  The new income exemption amounts for the alternative minimum tax are: $70,300 for single taxpayers (up from $54,300), $109,400 for married filing joint taxpayers (up from $84,500), and $54,700 for married taxpayers filing separately (up from $42,250).  These exemption amounts remain in effect until the alternative minimum taxable income reaches $500,000 for single taxpayers as well as married taxpayers filing separately (MFS) and $1,000,000 for married taxpayers filing a joint (MFJ) tax return when those exemption amounts begin to be phased out.  The phase out rate is 25%; therefore, the alternative minimum tax would not apply until a single taxpayer’s alternative minimum taxable income reaches $781,200, MFJ taxpayers’ alternative minimum taxable income reaches $1,437,600, and MFS taxpayers’ alternative minimum taxable income reaches $718,800.  These exemption amounts also will be adjusted for inflation each year.

The individual standard deduction for those taxpayers who don’t itemize their deductions is essentially doubled in 2018 to $24,000 (up from $12,700 in 2017) for married couples filing a joint tax return, $12,000 (up from $6,350 in 2017) for single taxpayers, and $18,000 (up from $9,350 I 2017) for those individuals qualifying for head of household status.  However, the personal exemptions for both taxpayers and dependents has been eliminated allowing for no additional deductions for personal exemptions.

Instead of personal exemptions, the child tax credit has been doubled from $1,000 to $2,000 for dependent children under the age of 17.  In addition to the child tax credit, there is a new “other dependent” tax credit of $500 per other dependent.  Under old tax law, the child tax credit was phased out allowing no tax relief for single taxpayers whose adjusted gross income was more than $75,000 and married couples filing a joint tax return whose adjusted gross income was more than $110,000.  Under the new tax law beginning in 2018, those phase-out limits have now been increased to $200,000 for single taxpayers and $400,000 for married taxpayers filing a joint tax return.  This will allow more taxpayers with children under the age of 17 to take advantage of the full $2,000 per child tax credit.

Additionally, there was a smaller amount under old tax law that could be considered a “refundable credit”.  The new tax law allows for up to $1,400 of the child tax credit to be considered refundable.  The “refundable credit” becomes significant when a taxpayer’s tax liability does not equal or exceed the child tax credit. A “refundable credit” means that if a taxpayer has any excess credit amount over his or her tax liability, then that excess amount may be refunded to him or her.  For example, assume a married couple has three children all under age 17 and has $40,000 of taxable income.  Based on the new tax tables, their tax liability would be $4,739.50.  They would be entitled to claim a child tax credit of $2,000 per child, or $6,000.  The child tax credit would effectively wipe out their entire tax liability and there would be an excess (Tax liability of $4,739.50 – Child Tax Credit of $6,000 = negative $1,260.50).  Since up to $1,400 per child of child tax credit can be considered a “refundable credit”, the entire $1,260.50 in the example would be refunded to the taxpayers.

Now let’s assume a single taxpayer with no children was in the 24% tax bracket with $100,000 of adjusted gross income and no itemized deductions.  Under the old law, the taxpayer would be allowed a personal exemption of $4,100 and a standard deduction of $6,350 which would have resulted in taxable income of $89,550 and a tax liability of $18,126.25.  Under the new law, the taxpayer is entitled to a $12,000 standard deduction and a $500 tax credit.  The taxable income would be $88,000 with a tax liability of $15,409.50 less the $500 tax credit resulting in a net tax liability of $14,909.50, or an overall tax reduction in this example of $3,213.75.

CAPITAL GAINS

Essentially, the capital gains tax rates and limits have remained the same.  Under the old tax law, taxpayers in the 10% or 15% regular tax brackets would owe nothing on their long-term capital gains and qualified dividend income.  Those in regular tax brackets 25% through 35% would owe 15% on their long-term capital gains and qualified dividend income.  Those taxpayers fortunate enough to be in the highest regular tax bracket (39.6%) would owe 20% on their long-term capital gains and qualified dividend income.  There is the additional Net Investment Income Tax of 3.8% on net investment income, including capital gains and dividend income, for those single taxpayers with adjusted gross incomes of $200,000 or more and married taxpayers filing joint tax returns with adjusted gross incomes of $250,000 or more and $125,000 for married taxpayers filing separately.

The capital gains breakpoints (ie, the regular tax bracket limits) are different under the new tax law!  

Under the new tax law, the 0% long-term capital gain and qualified dividend income tax bracket is based on taxable income less than or equal to:

  • $77,200 for married filing joint tax returns (Note: 12% regular tax bracket goes to $77,400)
  • $38,600 for single and married taxpayers filing separate tax returns (Note: 12% regular tax bracket goes to $38,700)
  • $51,700 for head of household filers (Note: 12% tax regular tax bracket goes to $51,800)
  • $2,600 for estates and trusts (Note: 12% regular tax bracket goes to $2,550).

The 15% long-term capital gain and qualified dividend income tax bracket is based on taxable income less than or equal to:

  • $479,000 for married filing joint tax returns (Note: 37% regular tax bracket goes to $600,000)
  • $425,800 for single taxpayers (Note: 37% regular tax bracket goes to $500,000)
  • $239,500 for married taxpayers filing separate tax returns (Note: 37% tax bracket goes to $300,000)
  • $452,400 for head of household filers (Note: 37% tax regular tax bracket goes to $500,000)
  • $12,700 for estates and trusts (Note: 37% regular tax bracket goes to $12,500).

The 20% long-term capital gain and qualified dividend income tax bracket would is based on taxable income greater than:

  • $479,000 for married filing joint tax returns (Note: 37% regular tax bracket goes to $600,000)
  • $425,800 for single taxpayers (Note: 37% regular tax bracket goes to $500,000)
  • $239,500 for married taxpayers filing separate tax returns (Note: 37% tax bracket goes to $300,000)
  • $452,400 for head of household filers (Note: 37% tax regular tax bracket goes to $500,000)
  • $12,700 for estates and trusts (Note: 37% regular tax bracket goes to $12,500).

Therefore, a married couple filing jointly with taxable income of $500,000 would be in a regular income tax bracket of 35% (not the highest marginal tax bracket under the new law) and having $10,000 in long-term capital gain and qualified dividend income would owe $1,500 in capital gain tax under the old law system ($10,000 x 15%).  Under the new law, the taxpayers would owe $2,000 in capital gain tax ($10,000 x 20%) since they had taxable income that exceeded $479,000.

The reason for the difference in tax theory from old tax law to new tax law is that under the new tax law, the capital gain tax bracket breakpoints uses a different inflationary index: CPI-U (Consumer Price Index for All Urban Consumers) which is less favorable versus the CPI (Consumer Price Index) computed by the Bureau of Labor Statistics.  The result is that, as taxable income increases (including the marginal tax brackets) under the CPI method, the capital gains tax brackets will not increase at the same rate under the CPI-U method.

For tax years beginning after December 31, 2017, recharacterization of ROTH IRA conversions is repealed no longer allowing the re-conversion back to a regular IRA.

Gift tax exclusion amounts for 2018 are $15,000 per person (up from $14,000 per person in 2017) per donor.

For taxpayers who become deceased between 2018 and 2025, the estate valuation exclusion has been doubled.  For 2018, the estate value exclusion is $11,200,000 (was schedule to be $5,600,000).

Student loan interest will continue to be deductible subject to the same adjusted gross income phase out limitations.

Teachers can still deduct up to $250 in school supplies in addition to the standard deduction of itemized deductions.

The medical itemized deduction, which had been discussed as a possible repeal, was retained by this tax package.  In fact, not only was it retained, but for 2017 and 2018 the adjusted gross income phase-out limitation was reduced from 10% to 7.5% of taxpayers’ adjusted gross income giving taxpayers the potential to deduct more of their personal medical costs for 2017 and 2018.

If you itemized your tax deductions, there are additional limits on those (as well as relief from other limitations).  

  • Medical deductions are retained and the phase out is reduced from 10% to 7.5% of adjusted gross income for the years 2017 and 2018.  Medical deductions will continue to be allowed after 2018, but the phase out limit is increased back to 10%.
  • Property, state, and local taxes will be limited to $10,000.
  • Home mortgage interest deduction will be limited to interest paid on up to $750,000 of principal mortgage acquisition debt for those mortgages acquired after 2017.  Older mortgages still qualify under the old law (ie, $1,000,000 of principal mortgage acquisition debt).
  • Cash charitable contributions can now be deducted to the extent that those contributions do not exceed 60% of adjusted gross income (was limited to 50% of adjusted gross income under prior law).
  • Casualty losses incurred for the years 2018 through 2025 will be limited to only those incurred in a “Federally Declared Disaster Area”.

Miscellaneous itemized deductions will not be deductible for the years 2018 through 2025:

  • Employee Business Expenses
  • Employee Office-In-Home Expenses
  • Brokerage Investment Management Fees
  • Job-Hunting Expenses
  • Professional or Union Dues
  • Professional or Investment Publications
  • Legal Fees-Personal
  • Professional Licenses
  • Uniforms
  • Employee Educational Expenses
  • Tax Preparation Fees-Personal

Under prior law, if a taxpayer’s income was too high, the total itemized deductions were limited and phased out so that at worst, the result was that only 20% of the total of these deductions actually became deductible.  Under the new law, this phase out will not apply for the years 2018 through 2025.

Beginning in 2018, Section 529 Plans for college education costs will now be able to be used for K-12 private, public, or religious schools.  Contributions to these plans remain non-deductible but the income earned is tax-free when distributions from the plan is for qualified education costs to the extent those distributions do not exceed $10,000.

Moving expenses will now be non-deductible except for any individual in the Armed Forces on active duty who is required to move pursuant to a military order and the move is a permanent change of station.  This includes employer reimbursements that were formerly non-taxable to employees as a fringe benefit; these payments will now be required to be added to the employee’s taxable salary.

For any divorce agreements entered into after December 31, 2018, the deduction of alimony will no longer be deductible nor will the receipt of alimony be taxable.  This would include any modifications to divorce agreements after December 31, 2018 that modifies amounts of alimony.

And last but certainly not least, beginning in 2019, the penalty portion of the “Obamacare” that required all individuals to purchase health insurance is repealed.  This basically takes the requirement away and give the choice back to Americans to decide whether they want to purchase health insurance, either through the insurance exchanges or privately.

The following are comparisons of individual tax brackets for 2017 with those coming in 2018:

COMPARISON OF 2017 (OLD BRACKETS) WITH 2018 (NEW BRACKETS)

Click HERE for a link to the Full GOP Tax Bill – 2017.

 

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