Analysis of the Tax Cuts and Jobs Act for Individuals
Recently President Trump signed into law sweeping tax reform commonly known as the Tax Cuts and Jobs Act (the Act). The whole process went rather quickly and there is a lot to digest in the Act. Tax advisors everywhere are trying to wrap their heads around all the changes; however, we’ve attempted to boil it down to items we feel might be most impactful to you and your family.
Previous Rules: Individuals are subject to income tax on “ordinary income,” Currently those rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
New Rules: Beginning with the 2018 tax year and continuing through 2025, there will still be seven tax brackets for individuals, but their percentage rates will change to: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Analysis: While these changes will lower rates at many income levels, determining the overall impact on any particular individual or family will depend on a variety of other changes made by the Act, including increases in the standard deduction, loss of personal and dependency exemptions, a dollar limit on itemized deductions for state and local taxes, and changes to the child tax credit and the taxation of a child’s unearned income, known as the Kiddie Tax.
Alternative Minimum Tax:
Previous Rules: Before the Act, a second tax system called the alternative minimum tax (AMT) applied to both corporate and non-corporate taxpayers. The AMT was designed to reduce a taxpayer’s ability to avoid taxes by using certain deductions and other tax benefit items. The taxpayer’s tax liability for the year was equal to the sum of (i) the regular tax liability, plus (ii) the AMT liability for the year.
New Rules: The Act doesn’t repeal the AMT for individuals, but it does increase its exemption amounts for tax years 2018 through 2025, making it less likely to hit at lower income levels. Furthermore, the exemption from AMT is phased out at a much higher income level.
Analysis: Many taxpayers (and CPAs) were hoping that the Act would scrap the AMT; however, only the corporate AMT was repealed. Therefore, taxpayers must continue to calculate their AMT. However, the increased amount exempt from AMT, coupled with the higher phase-out threshold should see a drop in the number of taxpayer’s affected.
Net Operating Losses:
Previous Rules: A net operating loss (NOL) deduction is allowed in computing taxable income for a tax year in an amount equal to the aggregate of the NOL carryovers and NOL carrybacks to that year. Under pre-Tax Cuts and Jobs Act law, the NOL deduction wasn’t subject to a limitation based on taxable income. Also, a net operating loss (NOL) for any tax year was generally carried back two years, and then carried forward 20 years.
New Rules: The Act limits the NOL deduction to 80% of taxable income, determined without regard to the NOL deduction itself. Carryovers to other years are adjusted to take account of the 80% limitation. The Tax Cuts and Jobs Act repeals the general two-year NOL carryback and the special carryback provisions, but provides a two-year carryback for certain losses incurred in a farming trade or business. The Act also provides that NOLs may be carried forward indefinitely.
Analysis: This provision limits the value of NOLs, because they can no longer completely eliminate the taxable income in a given year. It’s worth noting that losses that began before January 1, 2018, won’t be subject to the 80% limitation, so taxpayers will have to distinguish between the two. The repeal of the NOL carryback rule will hurt those who would like to have access to refunds quicker; however, the ability to carryforward these indefinitely might help those with large NOLs relative to their income.
Previous Rules: For 2017, the inflation-adjusted basic standard deduction was $12,700 for joint filers and surviving spouses (computed as 200% of the single filers’ amount); $9,350 for heads of household; and $6,350 for singles and marrieds filing separately.
New Rules: the standard deduction dollar amounts are increased to:
- (a) $24,000 for joint filers and surviving spouses
- (b) $18,000 for heads of household
- (c) $12,000 for singles and marrieds filing separately
Analysis: This is really a great deal for lower-income taxpayers, many of whom claim the standard deduction. It shields more income from taxation, and for those who will no longer itemize, it simplifies their reporting. It will be interesting to see what effect this doubling might have on charitable organizations, as many people will no longer see the direct tax benefit of their charitable activities as they will now take advantage of the higher standard deduction.
Miscellaneous Itemized Deductions:
Previous Rules: Individuals who itemized their deductions could deduct certain miscellaneous itemized deductions to the extent that the aggregate of those deductions exceeded 2% of adjusted gross income (AGI).
New Rules: Miscellaneous itemized deductions aren’t allowed under The Act for any tax year beginning after Dec. 31, 2017, and before Jan. 1, 2026.
Analysis: Many popular deductions will be eliminated including: unreimbursed business expenses, investment expenses, tax return fees and hobby expenses.
Previous Rules: For 2017, the (inflation-adjusted) amount deductible for each personal exemption was $4,050.
New Rules: The Act provides that, for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the exemption amount is zero.
Analysis: On the surface, this would appear to hurt large families; however, the higher standard deduction (noted above) coupled with expanded child tax credit (noted below) and lower brackets could mitigate the loss of the exemptions for many.
Previous Rules: Three tax brackets currently apply to net capital gains, including certain kinds of dividends, of individuals and other non-corporate taxpayers: 0% for net capital gain that would be taxed at the 10% or 15% rate if it were ordinary income; 15% for gain that would be taxed above 15% and below 39.6% if it were ordinary income, or 20% for gain that would be taxed at the 39.6% ordinary income rate.
New Rules: The Act, generally, keeps the existing rates and breakpoints on net capital gains and qualified dividends. For 2018, the 15% breakpoint is: $77,200 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $51,700 for heads of household, and $38,600 for other unmarried individuals. The 20% breakpoint is $479,000 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $452,400 for heads of household, and $425,800 for any other individual (other than an estate or trust).
Analysis: Basically no changes were made to capital gains, and the related preferential tax treatment. Worth noting is that for the high earners, the 3.8% net investment income tax is still in play. Also worth noting is that these rates sunset on December 31, 2025, unless extended.
State and Local Taxes (SALT):
Previous Rules: Individuals were permitted to claim the following types of taxes as itemized deductions, even if they were not business related:
- (1) state, local, and foreign real property taxes;
- (2) state and local personal property taxes; and
- (3) state and local income taxes
Taxpayers could elect to deduct state and local general sales taxes in lieu of the itemized deduction for state and local income taxes.
New Rules: For tax years 2018 through 2025, the Act limits deductions for taxes paid by individual taxpayers in the following ways:
- . . . It limits the aggregate deduction for state and local real property taxes; state and local personal property taxes; state and local; and general sales taxes (if elected) for any tax year to $10,000 ($5,000 for marrieds filing separately).
- . . . It completely eliminates the deduction for foreign real property taxes unless they are paid or accrued in carrying on a trade or business or in an activity engaged in for profit.
To prevent avoidance of the $10,000 deduction limit by prepayment in 2017 of future taxes, the Act treats any amount paid in 2017 for a state or local income tax imposed for a tax year beginning in 2018 as paid on the last day of the 2018 tax year. So an individual may not claim an itemized deduction in 2017 on a pre-payment of income tax for a future tax year in order to avoid the $10,000 aggregate limitation.
Analysis: Originally, it looked like the deduction for state income taxes would be scrapped entirely, and the $10,000 would only apply to property taxes, so the revision was welcomed by many. However, for high income earners in high income and property tax states, the loss of their state income tax deduction in excess of $10,000 could be a big blow.
Previous Rules: You could deduct interest on up to a total of $1 million of mortgage debt used to acquire your principal residence and a second home, i.e., acquisition debt. For a married taxpayer filing separately, the limit was $500,000. You could also deduct interest on home equity debt, i.e., other debt secured by the qualifying homes. Qualifying home equity debt was limited to the lesser of $100,000 ($50,000 for a married taxpayer filing separately), or the taxpayer’s equity in the home or homes (the excess of the value of the home over the acquisition debt). The funds obtained via a home equity loan did not have to be used to acquire or improve the homes. So you could use home equity debt to pay for education, travel, health care, etc.
New Rules: Starting in 2018, the limit on qualifying acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately). However, for acquisition debt incurred before Dec. 15, 2017, the higher pre-Act limit applies.
And, importantly, starting in 2018, there is no longer a deduction for interest on home equity debt. This applies regardless of when the home equity debt was incurred. Accordingly, if you are considering incurring home equity debt in the future, you should take this factor into consideration. And if you currently have outstanding home equity debt, be prepared to lose the interest deduction for it, starting in 2018. (You will still be able to deduct it on your 2017 tax return, filed in 2018.)
Analysis: This provision will effect taxpayer’s who purchase larger principal residences; however, it’s worth reiterating that existing debt incurred prior to December 15, 2017 is grandfathered in under the $1 million limitation. Unfortunately, the home equity exclusion does not have a corresponding grandfather clause. As a result many taxpayers who used this type of debt for home improvements, education, vacations, etc. in the past will lose this deduction beginning in 2018.
Previous Rules: Under the current rules, an individual who pays alimony or separate maintenance may deduct an amount equal to the alimony or separate maintenance payments paid during the year as an “above-the-line” deduction. (An “above-the-line” deduction, i.e., a deduction that a taxpayer need not itemize deductions to claim, is more valuable for the taxpayer than an itemized deduction.)
And, under current rules, alimony and separate maintenance payments are taxable to the recipient spouse (includible in that spouse’s gross income).
New Rules: Under the Act rules, there is no deduction for alimony for the payer. Furthermore, alimony is not gross income to the recipient. So for divorces and legal separations that are executed (i.e., that come into legal existence due to a court order) after 2018, the alimony-paying spouse won’t be able to deduct the payments, and the alimony-receiving spouse doesn’t include them in gross income or pay federal income tax on them.
Analysis: It’s important to emphasize that the current rules continue to apply to already-existing divorces and separations, as well as divorces and separations that are executed before 2019.
Child Tax Credit:
Previous Rules: Under pre-Tax Cuts and Jobs Act law, individuals could have claimed a maximum child tax credit (CTC) of $1,000 for each qualifying child
under the age of 17.
New Rules: For a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2026, the Act, the maximum child tax credit is increased to $2,000, with the refundable portion not to exceed $1,400.
Analysis: The increased credit (including refundable portion) along with more generous phase-out thresholds should allow more families to benefit from this credit. However, no CTC is allowed to a taxpayer for any qualifying child unless the taxpayer includes the SSN of that child on the tax return for the tax year.
Section 529 Plans:
Previous Rules: Under pre-Tax Cut and Jobs Act law, tuition for elementary or secondary schools wasn’t a “qualified higher education expense,” so students/529 beneficiaries who had to pay it couldn’t receive tax-free 529 plan distributions.
New Rules: The Act provides that qualified higher education expenses now include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. Thus, tax-free distributions from 529 plans can now be received by beneficiaries who pay these expenses, effective for distributions from 529 plans after 2017.
Analysis: There is a limit to how much of a distribution can be taken from a 529 plan for these expenses. The amount of cash distributions from all 529 plans per single beneficiary during any tax year can’t, when combined, include more than $10,000 for elementary school and secondary school tuition incurred during the tax year.
Estate and Gift Taxes:
Previous Rules: Before the Act, the first $5 million (as adjusted for inflation in years after 2011) of transferred property was exempt from estate and gift tax. For estates of decedents dying and gifts made in 2018, this “basic exclusion amount” as adjusted for inflation would have been $5.6 million, or $11.2 million for a married couple with proper planning and estate administration allowing the unused portion of a deceased spouse’s exclusion to be added to that of the surviving spouse (known as “portability”).
New Rules: The Act temporarily doubles the amount that can be excluded from these transfer taxes. For decedents dying and gifts made from 2018 through 2025, the Act doubles the base estate and gift tax exemption amount from $5 million to $10 million. Indexing for post-2011 inflation, brings this amount to approximately $11.2 million for 2018, and $22.4 million per married couple, with some basic portability techniques.
Analysis: Obviously the increased exemption amounts will drastically reduce the number of taxpayers who will be affected by estate and gift taxes, and this is the most important estate planning change under the new law. However, this provision is set to sunset in 2025; and perhaps could be viewed as an opportunity to make an irrevocable gift to a generation skipping trust. This is a complex strategy, and should not be pursued without professional counsel.
New Rules: The Act has created a significant new tax deduction taking effect in 2018 which should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.
The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
Analysis: This deduction opens up a lot of tax planning opportunities, in particular with S. Corporations which are not service based; however, it is extremely complex. It can also be of benefit to businesses which hold substantial assets (even if they don’t pay salary) due to the 2.5% test above. Individual tax situations will need to be analyzed to determine the applicability of this deduction to each taxpayer. If you wish to work through the mechanics of the deduction with us, with particular attention to the impact it can have on your specific situation, please give us a call.
As you can see from this overview, there is a lot here. The bill which passed was far from perfect, and many technical corrections will have to be made to shore up unclear language and unintended consequences. Analyzing the effect with your tax advisor is crucial. If you would like more information or to discuss the impact of the law further, give us a call!
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