This morning, President Trump signed the Tax Cuts and Jobs Act into law. Some of the coming changes are fairly simple to understand, such as the change in tax rates, while other aspects, such as the pass-through income deduction, will take longer to completely decipher.
This is a more in-depth look at the tax reform bill recently passed by the House and Senate. This is not an all-encompassing review of tax reform but covers the key items that could impact you or your business. In general, many of the items related to businesses are permanent changes to tax law where the individual changes often only apply from 2018 to 2025.
Individual Income Tax Reform
Income Tax Brackets
Overall, the highest tax bracket has been reduced from 39.6 percent to 37 percent. Historically, the married filing separately status would be subject to higher tax brackets than the single filing status but under the new law, the marriage penalty only remains for those in the top tax brackets. The long-term capital gain and qualified dividend tax brackets are set to remain at the same bracket levels, but the brackets are to be set based on income levels that differ from the income tax brackets.
Federal Individual Income Tax Bracket Chart
(Tax years after December 31, 2017 through December 31, 2025)
Married Filing Joint (Taxable Income)
Head of Household
Married Filing Separately
|10%||Not over $19,050||Not over $13,600||Not over $9,525||Not over $9,525|
|12%||Over $19,050 but not over $77,400||Over $13,600 but not over $51,800||Over $9,525 but not over $38,700||Over $9,525 but not over $38,700|
|22%||Over $77,400 but not over $165,000||Over $51,800 but not over $82,500||Over $38,700 but not over $82,500||Over $38,700 but not over $82,500|
|24%||Over $165,000 but not over $315,000||Over $82,500 but not over $157,500||Over $82,500 but not over $157,500||Over $82,500 but not over $157,500|
|32%||Over $315,000 but not over $400,000||Over $157,500 but not over $200,000||Over $157,500 but not over $200,000||Over $157,500 but not over $200,000|
|35%||Over $400,000 but not over $600,000||Over $200,000 but not over $500,000||Over $200,000 but not over $500,000||Over $200,000 but not over 300,000|
|37%||Over $600,000||Over $500,000||Over $500,000||Over $300,000|
Long-Term Capital Gains and Qualified Dividend Tax Brackets
(Tax years after December 31, 2017 through December 31, 2025)
Married Filing Joint (Taxable Income)
Head of Household
Married Filing Separately
|0%||Not over $77,200||Not over $51,700||Not over $38,600||Not over $38,600|
|15%||Over $77,200 but not over $479,000||Over $51,700 but not over $452,500||Over $38,600 but not over $425,800||Over $38,600 but not over $239,500|
|20%||Over $479,000||Over $452,500||Over $425,800||Over $239,500|
Alternative Minimum Tax
For individuals, the alternative minimum tax (AMT) remains. Instead of the anticipated removal, the exemption levels and phase out thresholds have been temporarily increased. The exemption has been increased to $109,400 for married taxpayers filing joint (half that amount for taxpayers filing under married filing separately), and $70,300 for other individual taxpayers. The phase-out thresholds have been increased to $1,000,000 for married filing joint taxpayers and to $500,000 for other individual taxpayers. These amounts are intended to be indexed for inflation. This applies to tax years 2018 through 2025.
Net Investment Tax
This is an additional 3.8 percent tax that applies to investment income if certain thresholds have been reached. The current bill has not altered or adjusted this tax and it still remains.
The deduction for alimony payments is repealed alongside the treatment of alimony as part of gross income for divorce or separation instruments executed after December 31, 2018. In addition, it is indicated that this treatment applies to any modification to current instruments after the December 31, 2018, date. This is a permanent feature of the bill, so there is no expiration date for this treatment. This is meant to add parity between the treatment of spousal and child support and to simplify the tax code.
Gain Exclusion for Primary Residence
There were discussions to modify the current law; however, no changes were made under the final bill.
For tax years beginning after December 31, 2017, and ending prior to January 1, 2026, moving expenses are only deductible to members of the armed forces. Under the prior law, certain moving expenses were deductible for individuals.
For tax years following December 31, 2017, amounts that have been converted from a traditional IRA to a Roth IRA cannot be recharacterized to remove the Roth conversion. The conversions of funds within a traditional IRA to a Roth IRA is a taxable transaction. Under the prior law, amounts that were converted during a taxable year could be recharacterized by the due date of the tax return including extensions. This would allow a taxpayer whose Roth account lost money or if the tax from the conversion was higher than anticipated, to effectively change their mind before paying the tax due on the conversion.
Changes to Itemized Deductions
These modifications are temporary. Unless noted otherwise, these provisions apply to tax years 2018 through 2025.
- Medical deductions: For tax years 2017 and 2018, the deduction threshold will be 7.5 percent for all taxpayers, reduced from 10 percent. The same threshold applies for the AMT calculation as well. For tax years 2019 and forward, the threshold reverts back to the 10 percent.
- State and local taxes: The deduction for state income, sales, and property taxes have been capped in the aggregate to be $10,000 as an itemized deduction. This is a significant change for individuals living in high tax states. The conference agreement went one step further indicating that prepayment of 2018 taxes in 2017 will not be deductible until 2018.
- Mortgage interest: For home acquisition debt incurred after December 15, 2017, the deductible portion of interest is limited to $750,000 of indebtedness ($375,000 for married taxpayer filing separately). Debt incurred prior to the December 15 date is considered grandfathered in, so the cap will remain at $1 million. In addition, the deduction for home equity debt is repealed.
- Charitable contributions: The limitation on annual cash contributions is increasing from 50 percent to 60 percent of a taxpayer’s adjusted gross income. This will allow for a higher amount of deductible contributions before being forced to carry forward a deduction into a subsequent tax year. Deductions limited in a current tax year may be carried forward into a subsequent year for up to five additional years.
In addition, the bill reinforces the need for substantiations of donations of $250 or more.
For tax years beginning after December 31, 2017, payments made to collegiate institutions for seating rights or preferences to athletic events will no longer be deductible. Under the prior law, such payments were deductible up to 80 percent as a charitable contribution. This repeal is a permanent change.
- Personal casualty losses: Casualty losses will no longer be deductible unless they are attributable to a presidentially declared disaster area.
- Gambling losses: The deduction for gambling losses has been expanded to include gambling expenses. The deduction is still limited to gambling winnings.
- Overall limitation: The overall cap on itemized deductions, also known as the Pease limitation, has been repealed. Previously, if your adjusted gross income was above a certain threshold, a portion of your itemized deduction would be reduced.
- Two percent itemized deductions: Miscellaneous itemized deductions subject to the two-percent floor have been repealed. This category includes tax preparation fees, investment management fees, unreimbursed employee expenses and certain other expenses.
This was a highly anticipated change to simplify filings for most taxpayers. It’s estimated that about 120 million tax returns will be impacted. By almost doubling the standard deduction, itemizing will not be beneficial to many taxpayers. This is a temporary change that increases the standard deduction to $24,000 for married filing jointly, $18,000 for the head of household, and $12,000 for other individual filers. This provision is set to sunset for taxable years beginning after 2025.
For tax years starting after December 31, 2017, and before January 1, 2026, the personal exemption deduction has been suspended. Under current law, the maximum exemption deduction for each qualifying individual is $4,050.
Child Tax Credit
The child tax credit will be temporarily increased from $1,000 to $2,000 per qualifying child. The maximum refundable credit for a qualifying child is $1,400. In addition, a new temporary $500 nonrefundable credit for qualifying dependents other than qualifying children will be granted. The importance of a credit’s refundability is that a nonrefundable credit can only offset taxes due. A refundable credit allows individuals who do not owe tax (or not much tax) to receive a benefit. The income phaseouts have been increased substantially for these credits to $400,000 for a joint return and $200,000 for all others. These provisions are set to apply to tax years beginning after December 31, 2017, and are set to expire for tax years beginning after December 31, 2025.
Shared Responsibility Payment
The healthcare mandate, the penalty for the lack of essential healthcare coverage, is being repealed for healthcare coverage status beginning after December 31, 2018. The premium tax credits or subsidies for taxpayers purchasing their healthcare coverage on the market were not discussed within the tax bill.
Estate and Gift Tax
The gift and estate tax remains under the new legislation. The estate and gift tax exclusion has been temporarily increased from $5,000,000 to $10,000,000, with indexing for inflation. This temporary increase applies to decedents dying and gifts made after December 31, 2017, and before January 1, 2026.
Estate and Trust Income Tax brackets
Federal Estate and Trust Income Tax Bracket Chart
(Tax years after December 31, 2017 through December 31, 2025)
|10%||Over $0 but not over $2,550|
|24%||Over $2,550 but not over $9,150|
|35%||Over $9,150 but not over $12,500|
Pass-Through Business Tax Reform
Pass-Through Income Deduction
Owners of certain pass-through businesses will be allowed to deduct up to 20 percent of qualified business income from a partnership, S corporation, or sole proprietorship for tax years beginning after December 31, 2017, and ending prior to January 1, 2026. Note that service businesses, including the areas of health, law, consulting, athletics, and financial services, can only take the 20 percent deduction if they make less than $315,000 of taxable income married filing jointly, and $157,500 for other taxpayers. Electing small business trusts also qualify for the up to 20 percent deduction.
Other key qualified business income requirements to claim this deduction include:
- The income must be effectively connected with the conduct of a trade or business within the United States.
- The income does not include specified investment-related income, deduction, or loss.
- Qualified business income excludes reasonable compensation and guaranteed payments.
For each qualified business, the deduction is also limited to 50 percent of the business’ W-2 wages or 25 percent of wages plus a portion of the business’ unadjusted basis in its tangible assets. Additional clarification is expected in regards to certain provisions related to qualified pass-through business income.
For partnership interests transferred to a taxpayer in connection with the performance of services, the sale of such interests can be treated as a capital gain under both the new and prior law. This carried interest income remains a capital gain but will be subject to a longer holding period of three years in order to qualify for the long-term capital gain rate.
Under the prior law, if 50 percent or more of the total interest in the partnership’s capital or profits was sold or exchanged, a technical termination of the partnership would occur. The tax reform repealed the technical termination rules for tax years starting after December 31, 2017.
Partnerships with Foreign Owners
For sales and exchanges of a partnership interest on or after November 27, 2017, the gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The bill requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as non-separately stated income and loss. Further, the bill requires the transferee of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Substantial Built-In Loss
The partnership substantial built-in loss rules will be modified for transfers of interests after December 31, 2017, to include that a substantial built-in loss also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition. If there is a substantial built-in loss, there is a mandatory step-down of the basis of the assets in the partnership.
Basis in Partnership
For partnership tax years beginning after December 31, 2017, in determining the amount of a partner’s loss, the partner’s distributive shares under Code Sec. 702(a) of partnership charitable contributions and taxes paid or accrued to foreign countries or U.S. possessions will be taken into account.
S Corporations Converting to C Corporations
On the date of enactment of the bill, any Code Sec. 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during 6-tax year period beginning with the year of change. An eligible terminated S corporation is any C corporation which:
- is an S corporation on the day before the date of enactment,
- during the two-year period beginning on the date of enactment, it revokes its S corporation election, and
- all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.
Further, in the case of a distribution of money by an eligible terminated S corporation, any distributions can be allocated between the accumulated adjustments account and the accumulated earnings and profits account.
Corporate Tax Rate
Beginning January 1, 2018, the corporate tax rate will be changed to a flat 21 percent rate, replacing the current graduated rate structure. It removes the special tax rate for Personal Service Corporations (PSC) and corporate alternative minimum tax (AMT) is also repealed.
Bonus depreciation: For qualified property placed in service after September 27, 2017 and before January 1, 2022, bonus depreciation will be increased to 100 percent. Note that qualified property has been expanded to include both new and used property. The allowable bonus depreciation would then phase out as follows:
- 80 percent for property placed in service after Dec. 31, 2022 and before Jan. 1, 2024.
- 60 percent for property placed in service after Dec. 31, 2023 and before Jan. 1, 2025.
- 40 percent for property placed in service after Dec. 31, 2024 and before Jan. 1, 2026.
- 20 percent for property placed in service after Dec. 31, 2025 and before Jan. 1, 2027.
Section 179 depreciation: For property placed in service in tax years beginning after December 31, 2017, the maximum amount a taxpayer may expense under Section 179 will be increased to $1 million. In conjunction with the expense increase, the phase-out threshold will be increased to $2.5 million for total purchases.
Farm equipment: For farm equipment placed into service after December 31, 2017, the recovery period for most farm equipment is shortened from seven years to five years. Further, the bill also repeals the required use of the 150-percent declining balance method for farm equipment. However, the 150-percent declining balance will continue to apply to 15-year or 20-year property used in a farming business.
Luxury cars: The depreciation limit applying to luxury automobiles increases for property which bonus depreciation is not claimed. For passenger automobiles placed in service after December 31, 2017, the maximum amount of allowable depreciation is $10,000 for the first year, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years.
Qualified improvement property: For property placed in service after December 31, 2017, the distinction between qualified leasehold improvement, qualified restaurant, and qualified retail improvement property has been removed and a general 15-year recovery period for qualified improvement property is provided. As such, qualified improvement property is generally depreciable over 15 years and allowed section 179 expensing without regard to whether it is subject to a lease, placed in service more than three years after the date the building was first placed in service or made to a restaurant building.
1031 exchanges: For exchanges after December 31, 2017, the deferral of gain on like-kind exchanges is only allowed with respect to real property that is not held primarily for sale. Personal property, such as trucks or planes, are no longer eligible for the deferral.
Business Deductions and Credit Changes
For tax years beginning after December 31, 2017, the deduction for business interest is limited to the sum of:
- Business interest income
- 30 percent of AGI
- The floor plan financing interest of the taxpayer for the tax year
Any interest that is disallowed can be carried forward to the following year.
For pass-through entities, the determination is made at the entity level. For tax years beginning after December 31, 2017 and before Jan. 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion.
Note that there is an exemption from the above limitation for taxpayers other than tax shelters with average gross receipts that do not exceed $25 million for the three prior taxable-year periods. Farming businesses can opt out if they use ADS to depreciate farming property with a recovery period of ten years or more. Real property trades and businesses can opt out if they use ADS to depreciate real property used in a trade or business.
For tax years beginning after December 31, 2017, the Domestic Production Activities Deduction (DPAD) is repealed.
For tax years beginning after December 31, 2021, specified research or experimentation costs must be capitalized and amortized ratably over a five-year period.
Entertainment and Meal Expenses
For amounts paid or incurred after December 31, 2017, deductions for entertainment expenses will be disallowed. For amounts incurred and paid after December 31, 2017 and until December 31, 2025, the current 50 percent limit on meals will be expanded to include meals provided through an eating facility or cafeteria or for the convenience of the employer. After December 31, 2025, such amounts also become nondeductible.
Employee Fringe Benefits
The exclusion from including in an employee wages expenses associated with providing any qualified transportation fringe benefit related to the commuting between the employee’s residence and place of employment has been removed.
Employee Achievement Awards
For amounts paid or incurred after December 31, 2017 for employee achievement awards, a definition of “tangible personal property” is now provided for what may be considered an excludible employee achievement award. Tangible personal property shall not include cash, cash equivalents, gift cards, gift coupons or gift certificates, vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items.
Fines and Lawsuits
The bill adds changes to deductibility of certain fines and penalties, allowing the deductibility of payments made in either restitution (including remediation of property) or amounts required to come into compliance with any law that was violated or involved in the investigation or inquiry, that are identified in the court order or settlement agreement as restitution, remediation, or required to come into compliance. Further, amounts paid or incurred for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse which are subject to a nondisclosure agreement are no longer deductible.
For tax years beginning after December 31, 2017, executive compensation is limited to a $1 million deduction with no exceptions for commissions and performance-based compensation. Under a transition rule, the changes do not apply to any compensation under a written binding contract which was in effect on Nov. 2, 2017 and which was not modified in any material respect after that date.
For amounts paid or incurred on or after the enactment date, the deduction for state and local lobbying expenses is repealed.
New Credit for FMLA Wages
For wages paid in tax years beginning after December 31, 2017 and before Jan. 1, 2020, the bill allows a general business credit of 12.5 percent of the wages paid to qualifying employees during any period in which the employees are on family and medical leave (FMLA) if the rate of payment is at least 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent. The maximum amount of family and medical leave that may be taken into account with respect to any employee for any taxable year is 12 weeks.
Dividends Received Deduction
For tax years beginning after December 31, 2017, the 80 percent dividends received deduction for corporations that own more than 20 percent of the stock of another corporation is reduced to 65 percent, and the 70 percent dividends received deduction for corporations that own less than 20 percent of the stock of another corporation is reduced to 50 percent.
Small Business Changes
For tax years beginning after December 31, 2017, the bill increases the $5 million gross receipts test to $25 million gross receipts to determine what a small business is. As such, the cash method may be used by taxpayers, other than tax shelters, with average gross receipts that do not exceed $25 million for the three prior taxable-year periods.
The bill retains the other exceptions from the required use of the accrual method for qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities.
Taxpayers that meet the $25 million gross receipts test are not required to account for inventories. Further, the bill expands the exception for small taxpayers from the uniform capitalization rules. Under the provision, any producer or reseller that meets the $25 million gross receipts test is exempted from the application of section 263A.
Application of the above provisions will be considered a change in the taxpayer’s method of accounting under section 481.
Finally, the bill expands the exception for small construction contracts from the requirement to use the percentage-of-completion method if the contract:
- Is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract
- Is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test
The application of the exception for small construction contracts from the requirement to use a percentage of completion will be applied on a cutoff basis for contracts entered into after December 31, 2017.
Net Operating Loss Changes
For net operating losses (NOLs) arising in tax years ending after December 31, 2017, the two-year carryback is repealed. Further, for tax years beginning after December 31, 2017, the NOL deduction is limited to 80 percent of taxable income. However, NOLs for farming business can still be carried back.
International Business Changes
For tax years beginning after December 31, 2017, the bill will move the United States from a worldwide tax system to a participation exemption (territorial) system in which corporations will receive a 100 percent dividends received deduction (DRD) for dividends distributed from specified 10 percent owned foreign corporations (generally, any foreign corporation other than a passive foreign investment company that is not also a controlled foreign corporation (CFC)). Note that no foreign tax credit or deduction will be allowed for any taxes paid or accrued with respect to a dividend that qualifies. The DRD will be available only to C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs).
In the case of the sale or exchange after Dec. 31, 2017, by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code Sec. 1248, is treated as a dividend for purposes of applying the DRD provision described above.
For dividends received in tax years that begin after Dec. 31 2017, a domestic corporate shareholder’s adjusted basis in the stock of a “specified 10-percent owned foreign corporation” is reduced by the portion of any dividend received with respect to such stock from such foreign corporation that was not taxed by reason of a dividends received deduction in any tax year of such domestic corporation, but only for the purpose of determining losses on sales and exchanges of the foreign corporation’s stock.
To transition to the new system, the bill will impose a one-time deemed repatriation tax on unremitted earnings and profits to be paid over eight years. Illiquid assets will be taxed at eight percent, while cash and cash equivalents will be taxed at 15.5 percent.
With respect to base erosion payments paid or accrued in tax years that begin after Dec. 31, 2017, certain corporations with average annual gross receipts of at least $500 million are required to pay a tax. The bill establishes the Senate’s Base Erosion Anti-Abuse Tax (BEAT), with a tax rate of five percent in 2018 and 10 percent thereafter.
We will keep you updated on the Tax Cuts and Jobs Act as new information develops. Please feel free to contact your advisor with questions regarding your specific circumstances.