952-884-0184

2017 Tax Bill – “Tax Cuts and Jobs Act”

By the time you read this the President will have signed the most significant tax legislation since 1986. The following is a brief summary of those areas that we think will impact most of our clients in 2018 and in some cases, 2017.

Most of the changes that impact individuals will expire at the end of 2025 while the changes that impact corporations and business are made permanent. We expect there will be Technical Correction bills next year to adjust for flaws that are identified in this legislation. In the future we do think that some of the provisions in this bill will change and/or be repealed as political control changes through our normal election swings.

The following changes include the primary items related to individuals and most small businesses. The tax bill contains numerous other provisions that impact foreign income taxation as well as changes to the insurance industry taxation.

Individual Provisions

The tax brackets for individuals, trusts and estates are all changing and almost all individual taxpayers will see a lower federal tax liability.

Standard Deduction & Personal Exemptions

The standard deduction is increasing substantially but taxpayers are losing their personal exemption deduction. The winners are those taxpayers that have 3 or fewer dependents and the losers are those taxpayers that have more than 4 dependents.

This change will supposedly reduce the taxpayers that itemize from approximately 30%+ of all returns filed down to something in the 10%+ range according to Congress.

Kiddie Tax Modified

Under the current law the net unearned income of a child (i.e. interest & dividends) was taxed at the parent’s tax rate (if higher) with the exception of the first $2,100 which was taxed at the child’s rates. This created complexity to the return and resulted in delays in filing the child’s return until the parent’s return was completed.

Under the new law this rule goes away but the unearned income of the child is taxes according to the brackets for estates and trusts. This change is an improvement!

Capital Gains

Under current law, net capital gains are taxed at a maximum rate of 0%, 15%, or 20% depending on the level of taxpayer income.

The new law retains the provisions for favorable tax treatment for capital gains and qualified dividends and indexes the brackets for inflation.

Income from Pass-Through Entities

This is one of the most significant changes in the tax law and is an attempt to level the playing field with those businesses that are paying taxes at a corporate level whom are the benefactors of a significant tax cut with the reduction of the corporate tax rate to 21%.

A complete explanation would take several pages and any examples we use to explain this provision has exceptions that may limit the deductions. With that said, a brief summary with qualifiers follows:

What is the deduction?

For most small businesses, where the owners have a combined taxable income of less than $315,000 (joint) or $157,500 (single), they will be allowed a deduction equal to 20% of the “Qualified Business Income”. If you have a business that is operated as a sole proprietor and have a net profit for the year of $100,000 your deduction would be $20,000.

Who does it apply to?

All operating and passive businesses that are operating as sole proprietorships, partnerships, or S Corporations whose income is taxed at the individual level

What is “Qualified Business Income” (QBI)?

Generally speaking it is the net profit from any business discussed above. However, it excludes salaries (W-2 income) from S Corporation owners and “guaranteed payments” to partners paid from partnerships. It also includes income flowing from passive activities, MLP’s, and REITS.

The original Senate bill allowed the S Corporation W-2 and guaranteed payments from partnerships to be included as QBI. However, the final compromise bill specifically exempts this income from receiving the benefit of the 20% deduction. This change will certainly create planning opportunities to maximize the deduction without compromising the integrity of returns being filed.

Are there any businesses that do not qualify for this deduction?

The short answer is yes. If the activity is from a professional service such as an accounting firm, law firm, or healthcare they cannot take advantage of this provision if their income is over the thresholds discussed above. Surprisingly, architects and engineers were specifically excluded from the definition of professional services.

What happens if I am over the thresholds of $157,500 and $315,000 of taxable income

The rules change significantly and the computation changes.

You start with taking 20% of the QBI. However, the deduction cannot exceed 50% of your share of the W-2 wages paid by the business. For example:

The taxpayer is a 30% owner of a manufacturing S Corporation. Her share of income is $700,000, and her share of the W-2 wages of the S Corporation are $200,000. She is entitled to a deduction equal to the LESSER OF:

  1. 20% of $700,000, or $140,000, or
  2. 50% of her share of the W-2 wages of the S Corporation or $100,000

Thus, she can take a deduction of $100,000 on her return.

Alternatively, you have another calculation to make that might provide benefit. That formula is:

  • 25% of the wages paid by the business PLUS,
  • 5% of the original cost of property used in the production of income

The alternative option is pointed directly at taxpayers that own commercial and residential real estate either individually or through a flow through entity. To illustrate, let’s assume the commercial real estate was purchased for $2,000,000 10 years ago, the net rental income from this property is $300,000, and there are no wages paid to manage the property. The computation looks like this:

  • 20% of net rental income is $60,000
  • 50% of wages is $0
  • The lesser of the two computations is $0

Based on this calculation no deduction would be allowed. However, we get another crack at the deduction. The alternative calculation looks like this:

  • 25% of the wage is still $0
  • 5 % of $2,000,000 is $50,000
  • The deduction is a combination of the two or in this case, $50,000 which is lesser than 20% of the QBI of $60,000

Itemized Deductions

There are significant changes made to itemized deductions including the elimination of deductions that are common on many tax returns.

With the changes made to itemized deductions the standard deduction will come into play. If you are going to be on the “bubble” of itemizing a planning idea is to bunch deductions every other year to take advantage of your deductions and to maximize the standard deduction from year to year.

Child Tax Credit

Under current law a taxpayer can claim a child tax credit up to $1,000 per qualifying child under the age of 17.  The credit starts to phase out once taxable income hits $75,000 for single filers and $110,000 for joint returns. To the extent the credit exceeded the federal tax liability a portion of the credit was refundable.

For taxable years starting next year the credit is increased to $2,000 with the phase-out limits increased to $200,000 for single filers and $400,000 for joint returns. The amount refundable is increased to $1,400 per qualifying child if the credits exceed the federal tax liability. To qualify, each child must have a valid social security number. A Taxpayer Identification Number is no longer acceptable.

Alimony Deductions

Under the current law alimony is deductible by the payor, and includible in income of the payee.

For divorce or separation instruments executed after December 21, 2018, alimony will no longer be deductible by the payor, nor will it be taxable to the payee. For agreements entered into prior to this date the current tax rules will apply.

Education Incentives & 529 Plans

The House bill would have eliminated most of the current education incentives but all have been retained in the final bill.

Section 529 Plans can now be used to pay for qualified tuition for children in K-12 as well as post-secondary. This includes elementary and secondary public schools as well as private and religious schools.

Exclusion of Gain on the Sale of a Primary Residence

The old rules still apply and a taxpayer may exclude up to $250,000 of gain ($500,000 if married filing jointly), provided the taxpayer has owned and used the home as his or her primary residence for two of the previous five years.  Both the House and Senate bill would have changed the use period to five out of eight years.

Estate Taxes

Under the current rules, a taxpayer is entitled to an exclusion of nearly $5,500,000 which translates to an $11,000,000 exemption for married couples before an estate tax is imposed.

The final bill would immediately double the estate exemption to $11,000,000 for a single taxpayer and $22,000,000 for a married couple.

Alternative Minimum Tax (AMT)

Each taxpayer must calculate their tax twice. If the AMT is higher than the regular tax calculation you pay the higher of the two taxes. Unfortunately, if a taxpayer has significant real estate and state income taxes it is a tax that is quite common because of the low exclusions that are currently available.

The AMT is retained under the current bill but the exemption amount is increased to $109,400 from $86,200 for joint returns and surviving spouses and $70,300 from $55,400, for single taxpayers. In addition the phase-out provisions were significantly expanded. As a result we would expect to see a significant decline in the number of taxpayers that are subject to the AMT.

Individual Insurance Mandate

Under current law any individual who doesn’t maintain “minimum essential health care coverage” must pay a penalty to the IRS. The bill repeals this penalty starting in 2019.

 

Corporate Tax Rate

Under current law the top corporate tax rate is 35%. The final bill drops the corporate rate to 21%.

Cash Method of Accounting

Under current law you must use the accrual method of accounting if average gross receipts is in excess of $5,000,000. The final bill changes that to $25,000,000 of average gross receipts.

 

Bonus Depreciation

Under current law taxpayers can expense 50% of new qualifying property with phase-outs in future years.

The final bill allows 100% expensing of new and used qualifying property purchased and placed in service after September 27, 2017 and before January 1, 2023. Subsequent to 2022 the bonus depreciation is phases down and goes away starting in 2027.

Section 179 Depreciation

Under current law you can deduct up to $510,000 of qualifying property (both new and used) with the deduction phasing out starting once current year purchases exceed $2,000,000. The final bill moves this up to $1,000,000 with the phase-out starting with $2,500,000 of qualifying purchases.

The final bill also is expanded to include the hotel industry to be eligible for 179 expensing. In addition, improvements to non-residential real property for roofs, HVAC systems, fire and protection systems as well as security systems are all eligible for 179 expensing.

Interest Expense

Currently there is no limitation of the amount of interest that can be deducted against business income. Starting in 2018 business interest expense will be limited to 30% of “adjusted taxable income” which is a new term. Companies not subject to this limitation includes businesses with gross receipts of less than $25,000,000 and commercial real estate owners.

Net Operating Losses

Currently individuals and businesses that incur net operating losses can carryback the loss 2 years and then forward 20 years. The final bill changes this to not allow carrybacks and any carryforwards will be limited to 80% of taxable income.

Alternative Minimum Tax (AMT)

Starting in 2018 the 20% corporate AMT is repealed.

Recovery Periods for Real Property

The original House and Senate bills had provisions to reduce the depreciable recovery period of commercial and residential real estate down to 25-years from 49 and 27.5-years. This provision did not make the final cut.

However, the final bill cleans up several classification of depreciable property that we now have to deal with. Starting in 2018 the separate definitions of “qualified leasehold improvement”, “qualified restaurant”, and “qualified retail improvement” properties are now eliminated.

Starting in 2017, improvements that meet the definition of “Qualified Improvement” property are assigned a depreciable life of 15-years and depreciated using the straight line method. In addition, restaurant buildings placed in service after December 31, 2017 will have a depreciable life of 39-years as compared to the current life of 15-years.

Like-kind Exchanges

Under current law you can exchange real estate for a comparable asset without having to recognize gain assuming all criteria are met. In addition, a trade-in of personal property (vehicle or a piece of equipment) will generally be a tax-free exchange.

The final bill keeps the real estate 1031 exchange option available but all exchanges of personal property will no longer be eligible for tax-free treatment. For example if you have a piece of equipment that has been fully depreciated and you receive a trade-in value of $10,000 gain will be recognized on the transaction. However, you are also eligible for bonus depreciation or section 179 expensing which should allow you to offset the gain recognized.

Employer’s Deduction for Entertainment Expenses

Under current law an employer can deduct up to 50% of expense relating to meals and entertainment.

Under the final bill starting in 2018 all entertainment expenses are no longer deductible. This includes items such as sporting tickets, golf events, membership dues, facility use, and any other item that would be considered entertainment. This removes the subjective determination of whether such expenses are sufficiently business related.

However, the purchase of meals and related beverages will continue to be allowed at 50% of the expense assuming they are related to a business purpose.

Limitation on Excessive Employee Compensation

The deductions for certain employees working for a publicly traded company is limited to $1,000,000. Any compensation over that amount is not allowed. The final bill includes stock option value into this computation.

Deduction for Local Lobbying Expenses Eliminated

The final bill disallows a deduction for lobbying expenses with respect to legislation before local government bodies.

New Credit for Employer-Paid Family and Medical Leave

Starting in 2018 a credit can be claimed for wages paid to an employee who is on qualified family and medical leave subject to a plan and meeting certain requirements.

Planning Suggestions

Most of the provisions in the bill are effective for 2018 but as a general rule the following recommendations should be considered if you still have time for last minute planning.

  • You can still make a 4th quarter state tax estimate. There is wording in the final bill that appears to preclude or limit the amount that can be made. However, we have had conversations with a national tax leader that the language in the bill was put there to prevent someone from prepaying their entire 2018 tax state tax payment in 2017 thus, claiming the deduction in 2017 and avoiding the $10,000 bucket for the limitation for real estate taxes and state income taxes. A reasonable payment (even if it results in a refund on your 2017 state return) should be consider provided you are not in an AMT situation. If you are subject to AMT, the state tax payment will not reduce your federal tax liability
  • Defer income into 2018 if you expect the lower rates to benefit you.
  • Accelerate deductions into 2017 if you are going to be subject to the standard deduction.
  • If you are close to the standard deduction amount consider “bunching” your itemized deductions so that every other year you itemize and the off year you claim the standard deduction.
  • Call us with questions to see if there is anything we can do to help with some last minute planning.

Seminars

Due to the timing of the legislation we have not scheduled any client education seminars/webinars but are planning to do so in January. If you are interested in attending please call our office and give Beth your name, phone #, and e-mail address and we will make sure you have a spot reserved.