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Tax Cuts and Jobs Act impacts U.S. tax returns

President Trump just signed in to law the Tax Cuts and Jobs Act (TCJA) which will impact every aspect of taxation reporting for – individual, corporate, partnership and other “pass through” business entities, estate, and even tax-exempt organizations.

The House passed the penultimate version of the bill on December 19, 2017, though for Senate procedural reasons, small changes were needed and a revote was held in the House.The Senate passed the final version on December 20 in a 51-48 vote and that final version was passed by the House of Representatives, also on December 20, 2017. The bill was signed into law by President Donald Trump on December 22, 2017.

Most of the changes introduced by the bill will go into effect on January 1, 2018, and will not affect 2017 taxes.  The TCJA is 1,097 pages of changes. Just think about the incredible impact on the tax code. It literally affects every aspect of taxation. Most Americans will focus on the impact to their Individual income tax return, Form 1040. However, those in business will need to dig deeper into the changes to completely understand their tax impact.  So, let’s start with the Individual changes.

Individual Taxation

There is much controversy in main stream media regarding the effects of the TCJA. The reality is that most high earning Californians will not see a tax cut, but rather a large reduction in their itemized deductions. Specifically, it will be the State, sales tax and property tax deductions. In California, these are considerable and will be seen in the example below. This will be complicated by the changes to the pass through entities for those business owners that have a subchapter “S” Corporation, LLC or partnership. This will be discussed below.

Virtually all taxpayers are impacted by the changes in the tax reform legislation. Those who itemize will have fewer expenses to deduct and a higher standard to cross. Changes to child-related refundable and non-refundable tax benefits will impact many California families.

The TCJA lowers most individual income tax rates, including the top marginal rate from 39.6 percent to 37 percent. Retains the current seven-bracket structure, but bracket widths are modified. See below:

Individual income tax brackets for Ordinary Income
Single Filers
Single filers (2018)[24]
Under previous lawTax Cuts and Jobs Act
RateIncome bracketRateIncome bracket
10%$0–$9,52510%$0–$9,525
15%$9,525–$38,70012%$9,525–$38,700
25%$38,700–$93,70022%$38,700–$82,500
28%$93,700–$195,45024%$82,500–$157,500
33%$195,450–$424,95032%$157,500–$200,000
35%$424,950–$426,70035%$200,000–$500,000
39.6%$426,700 and up37%$500,000 and up
Individual income tax brackets for Ordinary Income
Married filing Joint filers
Married Filing Jointly
Under previous lawTax Cuts and Jobs Act
RateIncome bracketRateIncome bracket
10%$0–$19,05010%$0–$19,050
15%$19,050–$77,40012%$19,050–$77,400
25%$77,400–$156,15022%$77,400–$165,000
28%$156,150–$237,95024%$165,000–$315,000
33%$237,950–$424,95032%$315,000–$400,000
35%$424,950–$480,05035%$400,000–$600,000
39.6%$480,050 and up37%$600,000 and up

See also: Income tax in the United States

Let’s Look at the Basic Changes

  1. The standard deduction has been doubled to $24,000 for married couples ($12,000 for individuals) and the personal exemption is eliminated.
  2. The overall limitation on itemized deductions is eliminated.
  3. The Alternative Minimum Tax (AMT) for individuals is maintained with a higher exemption level of $109,400 for married couples ($70,300 for individuals). Additionally, AMT exemption phase-out thresholds are increased to $1,000,000 for married couples ($500,000 for individuals). Given the increased exemption and phase-out thresholds as well as the limitation of certain itemized deductions, many clients may find that they are no longer subject to AMT.
  4. 1031 exchanges. The law continues to permit the deferral of taxes on the proceeds of the sale of real property when those proceeds are properly reinvested in similar property (“like-kind exchanges”). Beginning in 2018 this deferral is not available for other types of property.
  5. Roth IRA re-characterizations. Beginning in 2018, a conversion from traditional IRA to a Roth IRA can no longer be re-characterized back to the traditional IRA.

Provisions impacting individuals that were NOT affected by the Act. The following are items that were proposed and discussed but are NOT affected by the Act: –

  1. Treatment of sale or disposition of a partial position of securities (investors may still choose specific shares or lots to sell and will not be required to use FIFO treatment)
  2. Tax free treatment of employer sponsored health insurance
  3. Tax free treatment of graduate student tuition waivers –
  4. Deduction for student loan interest
  5. Exclusion of gain from the sale of a principal residence remains at $250,000 ($500,000 for married filing jointly) and the home must have been occupied 2 out of the last 5 years)
  6. The 3.8% tax on net investment income is retained

Other changes that were either eliminated, limited or modified:

Fully eliminated

  • Miscellaneous itemized deductions subject to the 2-percent floor
    • Employee business expenses
    • Tax preparation fees
    • Investment interest expenses
  • Personal casualty and theft losses (except for certain losses in certain federally declared disaster areas)

Limited

  • State and local income taxes (SALT) or state and local sales tax, plus real property taxes, may be deducted, but only up to a combined total limit of $10,000 ($5,000 if MFS) This is going to impact many Californians, since most of us pay way over the limit passed.
  • Home mortgage interest has several modifications:
    • Interest on a home equity loan is no longer deductible
    • Interest on a new home mortgage is limited to interest paid on a maximum of $750,000 ($375,000 if MFS) of a new mortgage taken out after December 14, 2017.
    • Taxpayers with a mortgage taken out before December 15, 2017 can continue to claim home mortgage interest on up to $1 million ($500,000 if MFS) going forward; the $1 million ($500,000 if MFS) limit continues to apply to a refinanced mortgage incurred before December 15, 2017.

Modified

  • Charitable contributions: The deduction for charitable contributions is expanded so that taxpayers may contribute up to 60% of their adjusted gross income, rather than up to 50%.
  • Gambling losses remain deductible, but only to the extent of gambling winnings. The definition of losses from wagering transactions is modified.
  • Medical expenses remain deductible. For 2017 and 2018, medical expenses are deductible to the extent they exceed 7.5% of AGI. In 2019, the threshold will increase to 10% of AGI.

The overall limit on itemized deductions (often called the Pease limit) is also eliminated by tax reform under President Trump. Most of the changes to itemized deductions will remain in place through 2025. In 2026, itemized deductions will generally follow the rules in place before the TCJA.

Many “Above-the-line” deductions eliminated, limited or modified

As with itemized deductions, many “above-the-line” adjustments have also been eliminated or limited:

Fully eliminated

  • Alimony deduction for payments made under orders executed after December 31, 2018. For new orders, the TCJA no longer allows payors to deduct alimony payments or requires the recipient to report income for alimony received. (Payments under existing orders are grandfathered and may continue to be deducted by the payor and should be reported as income by the recipient.)
  • Tuition and fees deduction expired under previous law and was not renewed by the TCJA.
  • Domestic production activities deduction (DPAD)   This deduction is against income derived from domestic manufacturing activities. The domestic production activities deduction is designed to encourage domestic production and production-related activities. It is also known as the “manufacturer’s deduction”.

Mostly eliminated

  • Moving expenses are disallowed (except for the expenses of active members of the military who relocate pursuant to military orders).

Child tax credit increased through 2025

Through 2025, the TCJA increases the maximum child tax credit from $1,000 to $2,000 per qualifying child. The refundable portion of the credit increases from $1,000 to $1,400. That means taxpayers who don’t owe tax can still claim a credit of up to $1,400. The higher child tax credit will be available for qualifying children under age 17, as under current law.

Also, the child tax credit begins to phase out for taxpayers with modified adjusted gross income (MAGI) of over $200,000 or $400,000 (MFJ). This phaseout more than doubles the phaseout range under current law. Taxpayers can’t claim a child tax credit for a child who does not have a Social Security Number (SSN) by the due date of the return.

In 2026, the child tax credit will change to the rules used in 2017, with a maximum credit of $1,000 per qualifying child, and lower phaseouts.

New credit for non-child dependents available through 2025

The TCJA allows a new $500 nonrefundable credit for dependents who do not qualify for the child tax credit. Taxpayers can claim this credit for children who are too old for the child tax credit, as well as for non-child dependents. There is no SSN requirement to claim this credit, so taxpayers can claim the credit for children with an Individual Tax Identification Number (ITIN) or an Adoption Tax Identification Number (ATIN) if they otherwise qualify.

Taxpayers cannot claim the credit for themselves or their spouse (if MFJ).

In 2026, the credit for non-child dependents will no longer

These stay the same

  1. Educator expense deduction (K-12 educators can deduct up to $250 per year for unreimbursed classroom supplies.)
  2. Student loan interest of up to $2,500 can be deducted by qualifying taxpayers for interest paid on student loans.
  3. Health savings account (HSA) deduction
  4. IRA deduction
  5. Deductions for self-employed taxpayers (SE tax, SE health insurance, SE qualified retirement plan contributions)

Some education benefits remain the same, others modified

  1. Taxpayers can continue to claim the American Opportunity Credit, a credit of up to $2,500 per year for the first four years of college education, and the lifetime learning credit, a credit of up to $2,000 per year for qualifying education expenses.
  2. Taxpayers can continue to use savings bonds for education, educational assistance programs provided by employers, 529 plans and Coverdell education savings plans to save for college. Some scholarships and tuition waivers can continue to be treated as tax-free if certain conditions are met.
  3. 529 plans can now be used for K-12 expenses.
  4. Plans can distribute up to $10,000 each year for tuition incurred for enrollment or attendance at a public, private, or religious elementary or secondary school.
  5. The $10,000 limit for elementary and secondary school is applied on a per-student limit.
  6. Taxpayers whose student loans are cancelled because death or total and permanent disability may be eligible to treat the cancellation of debt as tax-free.
  7. Health care penalty eliminated. The penalty for failure to obtain health insurance coverage (the “individual mandate”) will be eliminated beginning in 2019. Taxpayers who did not have coverage in 2017 or 2018 will continue to owe a penalty for those years, unless they qualify for an exemption.

Let’s see the effects of some of these changes on an individual return

A Chula Vista couple has a mortgage on a primary residence with $40,000 annual interest due, the picture would change as below:

20172018
Charitable$ 10,000$ 10,000
State and property taxes$ 70,000$ 10,000
Investment expenses$ 25,000
Mortgage interest$ 40,000$ 40,000
Limit on itemized deduction($10,086)
Total provisional deductions$ 134,914$ 60,000
Standard deduction$ 12,700$ 24,000
Final deductions taken$ 134,914$ 60,000
Lost deductions$ 74,914

 

It is still worthwhile for the couple to continue to itemize, but they will lose the economic benefit of some very costly deductions – most notably state and property taxes. Some benefit is regained because the limitation on itemized deductions does not apply

These changes will impact many Californians as they see their State, sales and property taxes reduced to the limited $10,000 allowable deduction.

Business Tax Changes

  1. The corporate income tax rate is permanently lowered to 21% beginning in 2018.
  2. AMT. The corporate alternative minimum tax is repealed beginning in 2018.
  3. Allows full and immediate expensing of short-lived capital investments for five years. Increases the section 179 expensing cap from $500,000 to $1 million.
  4. Limits the deductibility of net interest expense to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) for four years, and 30 percent of earnings before interest and taxes (EBIT) thereafter.
  5. Eliminates net operating loss carrybacks and limits carryforwards to 80 percent of taxable income.
  6. Eliminates the domestic production activities deduction (section 199) and modifies other provisions, such as the orphan drug credit and the rehabilitation credit.
  7. Enacts deemed repatriation of currently deferred foreign profits, at a rate of 15.5 percent for cash and cash-equivalent profits and 8 percent for reinvested foreign earnings.
  8. Moves to a territorial system with base erosion rules.  Companies’ desires to have freer access to offshore cash and to escape complex subpart F rules might conflict with their wanting to avoid an increased effective tax rate. For companies with rates in the single digits, a territorial system that comes with tighter base erosion and profit-shifting
  9. Establishes a 20 percent deduction of qualified business income from certain pass-through businesses. Specific service industries, such as health, law, and professional services, are excluded. However, joint filers with income below $315,000 and other filers with income below $157,500 can claim the deduction fully on income from service industries. This provision would expire December 31, 2025.

Discussion of the 20% – Pass Through Companies

Individuals, trusts and estates can deduct 20 percent of “qualified business income” (as defined in the statute) received from a “pass through” company. S corporations, LLCs, partnerships and sole proprietorships are all examples of pass-through’. At a 37% top federal tax rate, the 20% deduction approximates a 29.6% marginal federal rate, but is subject to many limitations.

Many terms have to be defined in order to understand what impacts the 20% calculation, and also the limitations imposed on this deduction.

Only domestic business income qualifies. Deductibility is restricted for taxpayers above $315,000 for married taxpayers filing jointly and $157,500 for individuals (indexed for inflation).

Qualified business income specifically excludes investment income such as long-term capital gains, dividends, interest income (other than when properly allocable to a trade or business), and amounts received under an annuity contract. Sunset. The provision affecting pass through individuals, trusts and estates

Above these thresholds some of the limitations to this deduction include:

  • a) The deduction cannot exceed the greater of:
    1. 50% of W-2 wages paid by the qualified business, or
    2. 25% of wages paid plus 2.5 percent of the unadjusted basis of tangible depreciable assets used in the business. Note: this provision allows real estate business with large capital investments but low wages paid to employees to still take advantage of the deduction.
  • b) The deduction is not available for “specified service business” including:
    1. Health
    2. Law
    3. Accounting
    4. Actuarial science
    5. Performing arts
    6. Consulting
    7. Athletics
    8. Financial services
    9. Brokerage services
    10. Businesses in which the principal asset is the reputation or skill of one or more of its employees or owners
    11. Businesses involving the performance of services that consist of investing and investment management trading or dealing in securities, partnership interests or commodities c) Multiple businesses are aggregated and the deduction is allowed against the total net qualified business income.

See attachments 1 & 2 for Operation of Section 199A

Sunset

  1. The provision affecting pass through entities “sunsets” for tax years beginning in 2026.
  2. As a result of this new deduction for pass-throughs on qualified business income, we should see if they could do advanced planning to take advantage of this provision for your pass-through businesses. In addition, in states like California with higher state income tax rates we may consider whether we should reorganize the business as a C corporation as opposed to an S corporation or other pass through entity.
  3. The SALT deduction remains available to C corporations without the limitations imposed on individuals. Any analysis should take into consideration the double taxation of C corporations when making dividends to shareholders, the potential for trapping appreciated property in a corporation, and the sunset provision of the pass-through rules under the Act.
  4. MLPs. Master Limited Partnerships qualify for the tax reduction associated with small businesses and pass through entities under the new law. That would mean the annual net income would benefit from that deduction and that the distributions after an investor’s tax basis is zero would benefit.  An MLP combines the tax benefits of a limited partnership with the liquidity that publicly traded securities — like stocks and bonds — offer. The limited partners, in turn, get to collect distributions from the MLP’s cash flow. Limited partners do not get involved in an MLP’s operations. Also, while limited partner units are publicly traded, general partner units usually are not.
  5. International. The text changes the taxation of foreign based income from a worldwide income system to a territorial based system, including deemed repatriation with tax at 15.5% tax on cash and equivalents and 8% on illiquid assets.

Conclusion:

We expect further guidance, additional rules and regulations in 2018 that will help clarify and expand on the framework of the Act. Given that many of the changes made by the Act are effective in 2018, clients should reach out to their tax and legal advisors quickly to understand how the Act impacts their individual situations.

Estate and Gift Tax

  1. Estate and gift taxes remain a part of the U.S. tax code, however, the exemptions have been doubled to $11,200,000 per transferor in 2018 ($22,400,000 for married couples). Inheritors will continue to receive the benefit of a “step up in basis” on assets included in a decedent’s estate to date of death value. The gift tax annual exclusion rises to $15,000 per year per recipient (this is not a change from current law – simply happens due to inflation adjustment).
  2. Sunset. This provision “sunsets” for decedents whose deaths occur after December 31, 2025. On January 1, 2026, the estate and gift tax exemption will revert to $5 million per person, adjusted for inflation after 2011.The Act directs that regulations be implemented to prevent the additional exemption used from being “clawed back” at death, even if the increase in exemption sunsets as it is scheduled to do.
  3. State estate taxes. Many states assess their own estate taxes, and those state estate tax systems will not be affected by the Act. Clients who live in states with a state estate tax may want to consider making lifetime gifts since the federal exemption amounts sunset. In doing so, however, clients should also consider whether the potential estate tax savings of lifetime gifts outweigh losing the “basis step-up” for assets held at death.
  4. On the death of the first spouse, many estate plans call for the creation of a trust funded with the maximum amount that can pass free of federal estate tax. The doubling of the federal estate tax exemption could result in a significant (and surprising) state level estate tax. Clients should consider whether a revision to their estate plan is appropriate. The following table reflects how much state estate tax would be due in each state that has an estate tax, assuming death on January 1, 2018 for taxable estates of $11.2 million and $22.4 million.
  5. California residents do not need to worry about a state estate or inheritance tax, which is a tax that is levied on people who either own property in the state where they died (estate tax) or inherit property from a resident of a state (inheritance).

Conclusion:

It should be remembered that the TCJA is 1,097 pages long. As a with all tax changes, we have to wait for the regulations to be printed to make sure that we are following the Congressional intent of the LAW as signed by President Trump. In other words, there is more to come.