This multifaceted legislation was passed by Congress during the week prior to Christmas, 2017. While there have been tax bills of some type virtually every year, this bill is the most comprehensive in decades, most likely back to the tax restructuring of the Reagan administration. The intent as stated was to provide simplification to a very involved and complex federal tax code AND to provide tax cuts across many areas of our society. Both of these objectives were accomplished in some ways, but never as much as they likely should be. But I digress.
The intent of this communication is to give you the sense of what we have studied and discovered up to this point regarding the new rules and law. Keep in mind that there are three things that determine how tax law is ultimately applied. The first is written law developed by Congress. That part of this bill is finished for now, assuming no significant legislation in the near future to change what has been passed. The second layer of tax rules involves regulations written primarily by the Internal Revenue Service as a response to new Congressional laws. Those regulations are developed to discuss how these new laws will be applied – the “how to”, if you will. While regulations are not supposed to define law in and of themselves, legislation passed by Congress is often too broad to be applied practically without further instruction – the possible interpretations have to be narrowed, in effect. Further, the regulations play the role of talking about specific steps that will allow these new rules to be applied, which forms, what instructions, and so forth. At this point, those regulations haven’t been written to any significant extent and will be forthcoming over the next several weeks and months. After all, as far as the IRS is concerned, they have most of a year to determine many of these regulations. Of course, you want to know those answers today! Accordingly, we are left with the task of making our own interpretations currently which may prove to need tweaking in the future.
And finally, until the legislative intent is tried in Tax Court and US District Court over the next five to ten years, the true interpretation by taxpayers and the IRS won’t be totally settled. Needless to say, that’s why this type of sweeping change must be interpreted so that you can respond accordingly, but you must hold those interpretations loosely as these other chapters are written. Stay tuned!
This document focuses on changes that affect individual taxpayers, as there are many rules that are truly clear and easy to understand in effect. The new rules for business owners are anything but simple, especially for small business owners. We will be developing additional information within the next few days relating specifically to the needs of our small business owners. Many businesses will need to be restructured to take advantage of these new rules. More to come!
Unless otherwise indicated, these new rules took effect on January 1, 2018.
So, with no further hesitation, let’s take a look! My apologies to Clint Eastwood and the famous movie title!
- Tax rates for individuals are going down. For married couples, the top rate of income tax will be 37%, which won’t be applied until a couple reaches $600,000 in taxable income. Previously, the highest rate is 39.6%, which is applied above $470,700 in taxable income.
- Singles are also seeing rate reduction. The top rates in both current and new laws are the same as for a married couple, but will be applied at $500,000 in taxable income. The 2017 taxable income level at which the highest rate is applied is $418,400. Both raising the taxable income threshold and lowering the rates are positives in this law, and should cause most individuals and couples to see a reduction of 2 to 4% in effective rate.
- Standard deductions are being increased! For 2017 and previous years, roughly one-third of taxpayers have used itemized deductions to achieve a benefit on their taxes, since their actual deductions were more than the previous standard deductions. Standard deductions have been almost doubled under the new law, to $24,000 for a married couple and $12,000 for a single individual. Estimates are that roughly one-half of the taxpayers who have itemized in the past will no longer receive a benefit for doing so in the future. If so, nearly five out of six taxpayers will use the standard deduction on their tax returns for 2018 and future years.
- Under prior law, the medical expenses for a taxpayer in any one year had to exceed 10% of income if that taxpayer was less than 65 years of age. That threshold has been reduced to 7.5% of income for 2018 and future years.
- Charitable deductions in general were limited to 50% of adjusted gross income under prior law, with any excess being carried forward to future years. This limit has been raised to 60% under the new rules.
- High income taxpayers under prior year experienced a “phase out” of their itemized deductions resulting in some of those deductions being mathematically eliminated. That phase out has been eliminated under the new rules.
- Many upper middle income taxpayers were subject to Alternative Minimum Tax under prior law. This tax has complex rules as to when it applies, but in general terms, it wasn’t unusual to see this tax come into play for a moderately high salaried individual or couple. The tax wasn’t eliminated under the new rules, but the threshold which determines when this supplemental tax will apply is being raised, resulting in less application of this tax to fewer taxpayers in the 2018 and beyond. Generally, much more income will be required for this tax to apply.
- This one could be a good or bad depending on which side of the transaction you are on. If you are a spouse who receives alimony, you will no longer have to pay taxes on the alimony you receive. Of course, if you are a spouse who pays alimony, you will no longer be able to deduct the amount you pay to your ex. Current divorce agreements and agreements reached by December 31, 2018 will be grandfathered under the old rules – still taxable and still deductible by the payer. But an agreement reached in 2019 or later years will be under these new rules.
- If you make contributions to your Section 529 savings plans during 2018 or later years, those contributions can be withdrawn for K – 12 education in the future tax free. Prior year contributions apparently cannot be used for this purpose. This is an area in which further definition will be important.
- Estate taxes have applied to a lot less individuals and couples over the past several years. If you died before 2018, only estates larger than $5,450,000 were subject to US estate taxes. Further, if you were married, you could in many circumstances use your spouse’s exemption, which meant no taxes unless your estate was over nearly $11,000,000. Most of us will not have an estate that large when we die! This has been increased in the new law to double those amounts for deaths occurring 2018 or later years – roughly $11,000,000 for an individual and $22,000,000 for a couple.
- The current individual mandate that is in the ACA (Obamacare) healthcare act requires individuals to have insurance or face penalties that are assessed on their income tax returns at the end of the year. While the mandate isn’t technically being changed, starting after 2018 the penalty is reduced to zero. This appears to indicate that there will still be a penalty assessed for failure to have coverage in 2018 when you file your tax returns in early 2019, but not after that date.
- For children of individuals and couples who are under 16 years of age, the prior law provided for an income tax credit of $1,000 per child subject to certain income limitations. This credit has been increased to $2,000 per child under the new rules, and the “phase out” limits would be higher as well, resulting in more taxpayers being able to take the new credits.
For most individuals, these changes will be positive and result in less income tax. As with all legislation passed by Congress, there are a lot of cost containment provisions in this bill as well. Have to pay for much of it with changes which “taketh away” some of the benefits. With that in mind –
- Prior law allowed for an exemption amount for each dependent to be deducted from income before taxable income was calculated. Exemptions have been eliminated under the new rules.
- State and local taxes were a component of itemized deductions in the past and will continue to be under the new bill. These deductions included primarily real estate taxes, state and local income taxes, personal property taxes and in some cases, sales tax paid. The new rules still allow all of these deductions but have put a cap of $10,000 per year on deductions in this area.
- Mortgage interest for acquisition of your primary residence is still deductible. This interest has been limited to loans of $1,000,000 under prior law. For example, if you bought a house in 2016 and took out a mortgage of $1,500,000 when purchased, you could only deduct 2/3 of the mortgage interest you paid, since interest paid on $1,000,000 of debt was all that could be included. The new rules take this limit down to $750,000, and will only be applied to new purchases after December 15, 2017. For existing acquisitions, the $1,000,000 limit will continue to apply.
- Home mortgage equity line interest will no longer be deductible during 2018 and future years.
- Many itemized deductions were categorized as “miscellaneous” under prior law and were subjected to a 2% income floor for deduction. Common examples of these deductions were employee job related expenses, union dues, tax preparation fees, investment fees and costs, and so forth. These deductions are no longer allowed under new law.
- When taxpayers moved from one area to another under prior law and took a new job in their new home area, moving expenses were allowed as a reduction of income. Beginning in 2018, moving expenses are no longer allowable unless the move is related to a military required move.
- Under prior law, losses that were the result of a casualty were deductible. This has been restricted under the new rules to only losses which occur in a presidentially declared disaster area.
In order to contain the cost of this bill, most of these provisions will only apply through 2025. Congress will have to take action at that time to extend or change these provisions or the law will revert to 2017 laws in place. Again, this is another cost containment area to keep the overall cost of the legislation contained.
And on we move to –
Business provisions in this bill were trumpeted as a major win in the media. Most of the attention was focused on the fact that prior US corporate tax rates were at a maximum of 35% and have been reduced to 21% under the new rules. This is a major win for US businesses in general, and will help make us more competitive with other corporate tax rate structures throughout the world.
However, the majority of small businesses use tax favored structures to pay their income taxes – S Corporations, Partnerships and Sole Proprietorships (Schedule C). These types of business structures do not pay corporate income taxes, but rather pay at the tax rates of their owners on the owners’ individual income tax returns. This tends to be an overall better strategy for the majority of small businesses for a variety of reasons.
Realizing that the smaller businesses were not going to benefit from the corporate income tax rate reduction, Congress included provisions in the new bill to allow some relief for small business taxes as well. Let’s applaud their efforts! In doing so, however, there were numerous provisions which resulted in a complexity that has changed the small business planning landscape for 2018 and future years. Many of the existing business structures being used for small businesses will need to change to take advantage of the new relief provisions awarded. As is usually the case, these new provisions work differently for businesses of different sizes and profitability levels. How business owners structure their compensation will also be key under the new rules.
The only true solution is a comprehensive review of each businesses circumstances to determine if structural changes or modifications to the compensation structures of the owners are necessary. Some of these changes will be extremely time sensitive and must be addressed during January. We will be reaching out to our business owner clients to discuss this on an individual basis over the upcoming days.