On December 22, 2017, the President signed the tax bill known informally as the Tax Cuts and Jobs Act (H.R. 1) (the “Act”) into law. Now the work of unpacking the Act and determining its impact on you, your family and the broader community begins in earnest.
Flexibility and focus on goals are key to financial wealth planning under the Act. Why flexibility? Because the Act provides many changes that impact individuals and businesses that will be effective at the start of 2018, but are not permanent. Why focus on goals? Because tax laws change, and goals endure.
The starts and stops under the Act can be a bit confusing. And no sooner will provisions of the Act come into effect in the New Year, than Congress and Treasury will begin the work of addressing technical corrections and writing the regulations to provide guidance for new provisions. Here are a few of the relevant milestones to keep in mind.
ESTATE, GIFT AND GENERATION-SKIPPING TRANSFER TAXES
Planning for family wealth transfer is first and foremost a question of goals. Taxes are just one of the many considerations to take into account in achieving your goals. The Act did not repeal the estate, gift and generation-skipping transfer taxes as originally proposed. It only increases the exclusion and GST exemption amounts for the next eight years (from $5 million to $10 million, adjusted for inflation).
The Act does not modify the current income tax basis rules related to gifts and transfers at death. The recipient of a lifetime gift of appreciated property receives the donor’s basis in the property (carryover). The recipient of property transferred at death receives a new fair market value basis in the property. Why is this important? If you give a beneficiary a low-basis appreciated asset during life and she sells it, she will incur a capital gain. If you give the same property to the same beneficiary at death and she sells it at that time, she will not incur a capital gain.
Planning for family wealth transfer with temporary tax rules adds an additional layer of complexity to tax-sensitive planning. This complexity is heightened when it incorporates estate, gift and generation-skipping transfer tax considerations as well as income tax considerations. If this was not enough, there are both federal and state level taxes to take into account. Having a wealth transfer plan that builds in flexibility is highly beneficial when dealing with a changing landscape and complexity.
There are a number of planning approaches that provide flexibility in an overall wealth transfer plan, including, for example:
ESTATE, GIFT AND GENERATION-SKIPPING TRANSFER TAXES
PASS-THROUGH BUSINESS INCOME TAX DEDUCTION
The Act creates a new income tax deduction for individuals, trusts and estates that own pass-through businesses. Pass-through businesses include sole proprietorships, partnerships, limited liability companies taxed as partnerships and S-corporations. The deduction equals 20% of qualified business income and is taken against the pass-through owner’s taxable income. For example, if Mary is a partner in a partnership and she is allocated $100 of the partnership’s net profits, her deduction is $20 (subject to limitations discussed below).
The overarching policy here is that, because the Act cuts the income tax rate for corporations that are taxed separately (“C-corporations”) from 35% to 21%, pass-through businesses also deserve some tax relief. The 20% deduction means that the maximum effective income tax rate for pass-through income is 29.6% for a taxpayer in the top 37% income tax bracket.
The 20% pass-through deduction is not automatic. There are six limitations on a taxpayer’s ability to take the deduction:
Thus far, this discussion has focused on pass-through businesses that operate at a profit. But what about pass-through businesses that generate losses, either because there is an economic downturn or because the business is starting up and re-investing to grow its business? Under the Act, individuals, trusts and estates that receive net business losses in excess of $250,000 (single / married filing separately) or $500,000 (married filing jointly), adjusted for inflation, cannot use the loss in the current taxable year. Instead, the individual, trust or estate must carry the loss forward to future taxable years under the net operating loss (“NOL”) rules. Thus, in those future years, the deduction would not be limited to $250,000 / $500,000 but instead would be limited to 80% of taxable income (determined before the loss deduction reduces taxable income) under the NOL rules.
A taxpayer that receives (a) real estate investment trust (“REIT”) dividends, (b) qualified cooperative dividends, and/or (c) qualified publicly traded partnership income like income earned through a master limited partnership also may be eligible for a deduction of up to 20%. However, for a REIT, only ordinary REIT dividends give rise to the deduction. Capital gain dividends from a REIT and qualified dividends from a REIT are not eligible for a deduction.
INDIVIDUAL INCOME TAX
When we think of individual income taxes we quite understandably focus on the balance due. But there is more to the story. Taxes raise revenue and promote policy objectives that, broadly speaking, reflect a common core of principles. Provisions of the tax law, old and new, are intended to encourage saving, investment, entrepreneurship, education and philanthropy.
The tax law continues to provide for reduced tax rates for qualified dividends and long-term capital gains, with a top rate of 20%. The new pass-through business income deduction discussed above is intended to promote capital investment. Saving for retirement by deferring compensation to fund 401(k) accounts and individual retirement accounts remains available.
The Act preserves and even enhances a number of education-related tax provisions. The American Opportunity credit and Lifetime Learning credit remain for eligible individuals. Discharge of student loans for taxpayers working in certain professions and areas with unmet needs remains income tax free. 529 education savings accounts are expanded to permit tax-free distributions for primary and secondary tuition (subject to annual limits) in addition to higher-education. And the list goes on.
In addition to its many non-tax benefits, charitable giving continues to have many tax-related benefits as well. Unlimited amounts may be given to charity during life or at death with an unlimited gift and estate tax deduction. In addition, lifetime gifts to charity continue to qualify for an income tax deduction for those who itemize their deductions, with some modest increases in long-standing limitations based on the donor’s adjusted gross income.
Wondering about the 3.8% net investment income tax? It remains in effect without change.
INDIVIDUAL INCOME TAX
CORPORATE INCOME TAX
One of the hallmark provisions in the Act is the change in tax rates for C-corporations. C-corporations, unlike pass-through entities, have two layers of income tax. First, the corporation itself pays income tax on its net income. Under the Act, the maximum income tax rate for C-corporations drops from 35% to 21%. There is no expiration date for the new 21% rate. The second layer of tax comes when a C-corporation pays a dividend to a shareholder and the shareholder pays income tax on the dividend at his personal income tax rate.
Domestic and international businesses will need to evaluate whether it makes sense to operate as a pass-through entity (such as a partnership or S-corporation) or whether a C-corporation makes sense. Considerations include: whether the business is generating gains or losses; exit strategy and potential for a tax-deferred exchange or tax-free liquidation; state and local income taxes; the 20% accumulated earnings tax and 20% personal holding company tax on corporations that do not make adequate distributions; the number of shareholders; and the impact of the new 20% pass-through business deduction and associated limitations.
The effects of the Act will not be immediately apparent for all affected individuals, families and businesses at the same time. Some may experience an impact with their first paycheck in 2018 if their withholding changes. Others may see adjustments in their 2018 estimated tax payments. Some may experience effects of the new law directly, others indirectly. All affected individuals, families, businesses and their advisors will continue to gain greater insight into the new law as technical corrections and new regulations emerge. We will address areas of specific focus in ongoing updates.