By Kenneth H. Bridges, CPA, PFS December 26, 2017
The Tax Cuts and Jobs Act (TCJA)1 was passed by the House and Senate on December 20 and signed into law by the President on December 22.
The actual text of the legislation is over 500 pages. The Conference Committee’s explanation runs another 560 pages. Throw in the signature pages and revenue estimates, and the total package runs 1,097 pages. I have tried to boil all that down here for you to just a few pages.
In order to (hopefully) make this somewhat more readable, I will break it down into a high level summary, business provisions, individual provisions (and new rate brackets), state tax impact, significant provisions from earlier proposals left out of final version, winners and losers, and actions to be taken (or not taken) by year end.
High Level Summary
From the 10,000 foot level, the new tax legislation:
- Cuts the maximum C-corp rate from 35% to 21%
- Moves the US (with respect to C-corps) from a “worldwide” system of taxation to more of a “territorial” system, with a one-time tax (with payment spread over 8 years) for earnings already parked off-shore
- Provides for a 20% deduction for “qualified business income” from certain flow-through entities and for sole proprietors
- Repeals the corporate AMT
- Repeals the domestic production activities deduction
- Provides for immediate expensing of most fixed asset purchases (other than land and buildings)
- Places new limits on business interest expense
- Limits the amount of business loss which can offset other sources of individual income
- Eliminates the ability to carry back an NOL
- Eliminates an inventor’s ability to get capital gains rate on sale of patent
- Preserves the R&D tax credit, but requires capitalization and amortization of R&D expenses after 2021
- Expands the number of companies which can use cash method
- Limits public companies’ deduction for executive compensation and provides an excise tax on the compensation of high-paid executives of tax-exempt organizations
- Eliminates the deduction for entertainment expenses
- Restricts 1031 exchanges to real estate only
- Eliminates the deduction for local lobbying expenses
- Reduces individual rates by approximately 3 percentage points for most income levels
- Significantly limits individuals’ ability to deduct state and local taxes
- Limits the interest deduction on new residential mortgages in excess of $750,000, and eliminates the deduction for interest on home equity loans
- Eliminates miscellaneous itemized deductions like investment expenses
- Eliminates individuals’ deduction for casualty and theft losses unless in Presidentially declared disaster
- Repeals the 3% of AGI limitation on itemized deductions
- Leaves individual AMT in place, but increases exemption levels and levels of income at which exemption is phased out
- Lengthens to 3 years the required holding period to get LTCG rate with respect to certain carried interests
- Doubles the standard deduction
- Repeals the deduction for personal exemptions
- Increases the child tax credit
- Permits the use of Section 529 plan money for elementary and secondary tuition
- Increases % of AGI which can be offset by charitable to 60%
- Temporarily decreases the AGI floor for deduction of medical expenses to 7.5%
- Changes alimony rules for agreements entered into after 2018
- Eliminates the deduction/exclusion for moving expenses (except Armed Forces)
- Eliminates the ACA individual shared responsibility payment
- Roughly doubles the estate tax exemption
Details follow below in the order listed above.
Reduction in corporate rate – Under pre-TCJA law, the top Federal rate on C-corp taxable income was 35%. Combined with effective state rates, the rate could be in excess of 40%. This was generally viewed as being uncompetitive globally. As a result of various deductions and credits, the actual effective rate (as a percentage of GAAP earnings) has generally been much lower (average probably closer to 20%), but clearly the high marginal rate has encouraged companies to attempt to relocate outside the U.S. or leave earnings parked offshore. Accordingly, the centerpiece of the new legislation is a reduction in the top Federal corporate rate to 21%, effective for 2018 and beyond. The Republicans had targeted a rate of 20%, but it was necessary to go to 21% in order to accommodate special interests and still meet the Senate budget requirements. The new lower rate applies for all corporations, including “personal service corporations” (e.g. accounting firms and law firms), which historically have been denied the benefit of the lower graduated corporate rates (and under original proposals would have been subject to a higher rate). As a practical matter, however, most professional service firms are flow-through entities and the second level of tax on C-corp distributions will likely still make the C-corp format undesirable for such firms. Privately-held companies in other industries will mostly be eligible for a new 20% deduction for “qualified business income of pass-thru entities” that will in most cases likely offset the benefit of converting to C-corp status. Accordingly, this reduction in the corporate rate is likely to primarily benefit publicly-traded companies, US subsidiaries of foreign companies, and companies owned by private equity firms.
Foreign provisions – The foreign-related provisions in TCJA are extensive and complex, but essentially move the US towards a “territorial based system” (i.e. US tax applies only to income earned domestically), while providing rules to prevent “base erosion”. The move towards a territorial based system is largely accomplished through the establishment of a “participation exemption system”, whereby a US parent company can claim a 100% deduction for foreign source dividends received from “specified 10% owned foreign corporations”. No foreign tax credit can be claimed with respect to this same income. The legislation provides for a one-time tax on the earnings of US companies’ foreign subsidiaries which are currently parked off-shore. The rate is generally 15.5% on liquid earnings and 8% on illiquid earnings, and the tax can be paid in installments over 8 years (8% per year in each of the first 5 years, followed by 15%, 20% and 25% in years 6 through 8, respectively). Related foreign tax credits have to be reduced proportionate to the benefit obtained from these lower rates.
20% deduction for flow-through income – Perhaps the most negotiated provision in the new tax legislation is the new deduction for “qualified business income of pass-thru entities” (which, in spite of the name, also applies for sole proprietors). These rules are complex, and this is an area likely to see a lot of action in terms of taxpayers trying to qualify for and maximize the deduction and the IRS trying to limit its application and curtail perceived abuse. The deduction is computed at the individual owner level, and is essentially a new type of deduction in that it does not reduce adjusted gross income but can be claimed without regard to whether you itemize. In general, the deduction is equal to 20% of K-1 “qualified business income”, which does not include interest, dividends and capital gains (so it appears you cannot double dip and get the lower rate on qualified dividends and capital gains while claiming this new deduction on the same income). For individuals with income in excess of $157,500 (or married couples with income in excess of $315,000, and in both cases subject to a phase-in), the deduction cannot exceed the greater of the taxpayer’s share of 50% of the W-2 wages paid by the business or 25% of the W-2 wages plus 2.5% of the original cost of the depreciable assets of the business. The deduction, while computed separately with respect to each flow-through business, cannot exceed the taxpayer’s combined qualified business income from all flow-through entities. Qualified business income must be effectively connected to a business conducted within the US, and losses carry forward to reduce such income in the following year. Reasonable compensation (including K-1 guaranteed payments) are excluded from qualified business income. “Specified services businesses” (any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees) are ineligible if the taxpayer’s income is in excess of $157,500 (or $315,000 for married couples, and in both cases subject to a phase-in). Engineering firms and architectural firms were originally on the list of ineligible businesses, but were removed from such list by the Conference Committee. The deduction is for income tax purposes only, not for computing self-employment tax or the 3.8% Medicare tax on net investment income. Qualified REIT dividends and K-1 income from publicly traded partnerships are eligible for the deduction, and estates and trusts are eligible to claim the deduction.
Corporate alternative minimum tax (AMT) – The corporate AMT is repealed. Otherwise, C-corps would have effectively received no benefit from certain tax credits like the R&D credit. Corporations which have incurred AMT in past years due to “timing differences” between regular tax and AMT rules will want to be sure to claim that amount back as a credit going forward. Also, those which have had other credits (e.g. the R&D credit) limited in past years by the AMT may be in a position to claim those credits going forward.
Domestic production activities deduction (DPAD) – The DPAD (up to 9% of profit from qualified production activities) is repealed for 2018 and beyond.
Section 179 and depreciation – As with most of this tax legislation, the new rules for depreciation or immediate expensing of fixed assets are complicated, but the basic gist of these rules is that via a combination of enhanced Section 179 expensing and bonus depreciation rules the cost of most depreciable assets (other than buildings, but now including qualified film, TV and live theatrical productions), whether new or used, placed in service from late 2017 (after 9/27/17) through 2022 can be immediately expensed. For years after 2022, small to midsize businesses will essentially retain this benefit (via the enhanced Section 179 deduction) while for larger companies the bonus depreciation amount will be phased down (80%, 60%, 40%, 20% and then 0% for years 2023 through 2027, respectively). The depreciation which can be claimed on luxury autos is also increased (e.g. from $2,560 to $10,000 for first year and from $4,100 to $16,000 for second year).
Business interest expense deduction – The deduction for business interest expense will generally be limited to 30% of “adjusted taxable income” (which is basically EBITDA for the first 4 years, and then EBIT thereafter). Companies with average annual revenue (computed over 3 years) of $25 million or less and also certain industries (most notably real estate if a proper election is made, but also floor plan financing of auto dealers and regulated utilities) are exempted from this rule. Real estate companies will have to accept slightly longer depreciation lives if they elect out of the interest expense limitation.
Excess business losses – Under current law, assuming a business loss from a flow-through entity is not limited by the basis rules, the at-risk rules, the passive activity loss rules or the hobby loss rules, it can generally offset any other income which you may have for the year (e.g. interest, dividends, capital gains) without limit. Under the new rules, the amount of business loss of an individual (as aggregated from all businesses) which can offset other sources of income is limited to $250,000 for singles and $500,000 for couples. Any amount in excess of this limitation becomes a net operating loss carryforward to the next year.
Net operating losses (NOLs) – Under current law, an NOL can be carried back 2 years or forward 20 years. TCJA eliminates the ability to carry back an NOL (except for the favored industries of farming and property & casualty insurance companies) and provides for an unlimited carryforward period, but limits utilization in carryfoward years to 80% of taxable income in the carryforward year.
Patents – Under TCJA, the sale of a patent will no longer be eligible for treatment as long-term capital gain if held by the inventor or a person or entity to which the inventor transferred the patent in a tax-free (carryover basis) transaction.
R&D – The R&D tax credit is retained. However, R&D expenses (including software development) incurred after 2021 will have to be capitalized (rather than expensed, as is currently the rule) and amortized over 5 years (15 years for R&D performed outside the US).
This rule, if it ever actually takes effect, could slip up on some smaller technology companies and have a devastating effect.
Expanded use of cash method – Under pre-TCJA law, generally C-corps or partnerships with a C-corp partner cannot use the cash method of accounting. An exception is made for C-corps with average annual receipts of $5,000,000 or less. TCJA increases that threshold to $25,000,000.
Executive compensation – Under pre-TCJA law, the deduction for compensation paid by a public company to its top five executives is limited to $1,000,000 per year each, except to the extent tied directly to performance. Under the new rules, the performance-based exceptions are eliminated, except for contracts which were binding as of 11/2/17. Tax-exempt organizations will (with some exceptions) incur a 21% excise tax with respect to compensation paid to an executive in excess of $1,000,000 per year.
Entertainment expenses – Under pre-TCJA law, 50% of entertainment expenses are deductible, so long as sufficiently connected to a business discussion. TCJA eliminates the deduction entirely for 2018 and beyond.
Like-kind exchanges – The ability to do a tax-free exchange of like-kind property is limited to real estate going forward.
Local lobbying expenses – The exception to the general prohibition on deducting lobbying expenses which applied to local lobbying is repealed. Accordingly, no deduction for lobbying expenses is permitted going forward.
Changes to individual rates – Under current law, ordinary income is subject to seven different rate brackets (10% to 39.6%), with the rate increasing as income increases. Long-term capital gains and qualified dividends are subject to lower rates (0%, 15% & 20%). The “Obamacare tax” on net investment income is in addition to these rates (3.8% for higher income taxpayers). The new legislation retains seven brackets but changes them to 10%, 12%, 22%, 24%, 32%, 35% and 37%. Rates on long-term capital gains and qualified dividends are essentially unchanged, and the 3.8% Medicare Tax on net investment income remains.
|Single||Marginal Federal Rate|
|$0 – 9,525||10%||10%||0%|
|9,525 – 38,700||15%||12%||-3%|
|38,700 – 82,500||25%||22%||-3%|
|82,500 – 157,500||28%||24%||-4%|
|157,500 – 200,000||28%||32%||4%|
|200,000 – 500,000||33%||35%||2%|
|Married Filing Joint||Marginal Federal Rate|
|$0 – 19,500||10%||10%||0%|
|19,500 – 77,400||15%||12%||-3%|
|77,400 – 165,000||25%||22%||-3%|
|165,000 – 315,000||28%/33%||24%||-4%|
|315,000 – 400,000||33%||32%||-1%|
|400,000 – 600,000||35%/39.6%||35%||-4.6%|
Heads of Household move through the rate brackets at an income level between that of Single and Married Filing Joint. Married Filing Separately is at the same level as Single up to $200,000 of taxable income, and thereafter moves into higher rate bracket at 1/2 the income level of Married Filing Joint. Estates and trusts move into the highest rate bracket at taxable income level of only $12,500.
You may note that there is a potential “marriage penalty” for a high earning couple, since joint filing will move them into the highest rate bracket more quickly that would two single filers with same level of income (about a $3,000 penalty). An additional similar potential marriage penalty exists with respect to the new limit on deduction for state and local taxes (limited to $10,000 for both singles and couples, so another potential $3,700 penalty for being married) and with respect to mortgage interest limitation (same dollar limitation for single and married couples).
Singles with income below $38,600 ($77,200 for couples) will continue to enjoy a 0% rate on qualified dividends and long-term capital gain. For singles with income below $425,800 ($479,000 for couples) the rate on such income will be 15%. The 20% rate applies if income is above these thresholds.
Limit on deduction for state and local taxes (SALT) – Under pre-TCJA law, individuals could take an itemized deduction for state and local income tax (or sales tax) and property tax. Probably the most contentious item in TCJA is the substantial limitation of such deduction. For years 2018 – 2025, an individual (or married couple) can take a deduction for state and local income tax and/or real estate tax not to exceed $10,000. For those whose income is primarily from long-term capital gains and qualified dividends, the alternative minimum tax under pre-TCJA law already often negated the benefit of this deduction. However, for individuals with substantial ordinary income, this deduction could be worth almost 40 cents on the dollar. Because a disproportionately large portion of the benefit of the SALT deduction has gone to residents of “blue states”, which tend to elect Democrats, this change is viewed by many as being very politically motivated. In order to capture the benefit of this deduction while it still lasts, you will in most cases want to make sure that you go ahead and pay any remaining balance of 2017 state income tax by December 31, 2017. Even if you lose some portion or all of the Federal benefit to the alternative minimum tax, you may still derive a permanent state tax benefit (depending on the state and whether the state adopts the new Federal rule). Note that paying 2018 tax by the end of 2017 will not accomplish anything, as Congress, aware that taxpayers might try this, included a highly unusual and very specific provision denying the deduction on 2017 returns for state income taxes which relate to a later year. There does not appear to be such a provision with respect to real estate taxes, but cities and counties generally do not have a mechanism which would permit prepayment of such taxes.
Mortgage interest – Under pre-TCJA law, individuals could deduct interest on up to $1.1 million of debt on primary home and a second home, with up to $100,000 of such debt being home equity indebtedness. Under the new rules, for mortgages taken out after 12/14/17 the maximum mortgage upon which interest will be deductible is $750,000. Debt incurred after 12/14/17 to refinance pre-12/15/17 debt will still qualify (with some limitation). For 2018 – 2025, the deduction for home equity indebtedness is eliminated.
Repeal of miscellaneous itemized deductions – Under pre-TCJA law, investment expenses and unreimbursed business-related expenses incurred as an employee are deductible, although a 2% of income limitation and addback in computing alternative minimum tax often eliminate the benefit. TCJA eliminates all miscellaneous itemized deductions for 2018 – 2025.
Casualty and theft losses – Under pre-TCJA law, casualty and theft losses are deductible if such exceed 10% of your income for the year. TCJA eliminates this deduction for 2018 – 2025, unless such losses incur in Presidentially declared disaster.
3% of AGI floor – Under pre-TCJA law, to the extent your income exceeds $261,500 as a single or $313,800 as a couple, your itemized deductions are reduced by 3 cents for each dollar of income thereafter. This limitation is repealed for 2018 – 2025.
Individual alternative minimum tax (AMT) – The individual AMT is retained, but with higher exemption amounts (e.g. $109,400 for couples in 2018 versus $84,500 for 2017) and higher thresholds of income at which the exemption is phased out (e.g. $1,000,000 for couples in 2018 versus $160,900 for 2017). The combination of the higher exemption amounts, higher thresholds for phaseout of exemptions, and repeal of deductions for state and local taxes and miscellaneous itemized (which were the causes of the AMT for most individuals) will mean that very few individuals will likely incur the AMT going forward. However, those with incentive stock options, passive ownership in flow-through entities which conduct R&D, or other “preference items” will still need to tread carefully, as the AMT may still bite them. Individuals who have incurred AMT in past years due to “timing differences” between regular tax and AMT rules will want to be sure to claim that amount back as a credit going forward. Also, those who have had other credits (e.g. the R&D credit) limited in past years by the AMT may be in a position to claim those credits going forward.
Carried interests – Under pre-TCJA law, the receipt of a “future profits interest” (a/k/a “carried interest”) is not subject to tax, and the character of future income from it is often long-term capital gain. The fact that hedge fund managers have been able to take advantage of these rules has repeatedly brought them in the bulls eye for potential tax legislation. During the campaign, Trump said carried interests should be taxed as ordinary income. The above notwithstanding, TJCA merely requires a 3-year holding period in order to qualify for long-term capital gains treatment, and gain which would otherwise be LTCG if not for the new rule will be taxed as short-term capital gain. The new rule is intended to apply only to “portfolio investment on behalf of third party investors”. Notably, real estate held for rental or investment comes under these rules.
Standard deduction – Individuals have the choice of either claiming itemized deductions or claiming a “standard deduction”. The new legislation roughly doubles the standard deduction amounts to approximately $12,000 for singles and $24,000 for couples for 2018 – 2025. This significant increase, combined with the elimination of the deductions for state and local taxes and miscellaneous itemized deductions will mean substantially fewer taxpayers will itemize. Nonprofit organizations fear this could mean a decrease in charitable contributions, since these taxpayers will no longer derive a tax benefit from charitable donations. Note that for many individuals the loss of personal exemptions (repealed by this legislation) will more than offset the benefit of the increased standard deduction.
Personal exemptions – Pre-TCJA law provided a personal exemption of $4,050 for each member of the family, with such amount being phased out for higher income taxpayers. TCJA eliminates the personal exemption for 2018 – 2025.
Child tax credit – The child tax credit is increased from the current level of $1,000 per child to $2,000 per child (up to age 17), with $1,400 per child being “refundable” (meaning the credit can exceed your otherwise tax liability). The credit continues to be phased out for higher income taxpayers, but at a higher level of income ($400,000 for joint filers; $200,000 for others). A credit of $500 can be received for dependents other than qualifying children.
Use of 529 plan money for elementary and secondary education – Under pre-TCJA law, money in Section 529 plans can be used tax-free only for college education (otherwise you incur tax and penalty on the earnings). TCJA changes this to permit the use of such for elementary and secondary education (with a $10,000 per year per student limit) for 2018 and beyond.
Charitable – TCJA largely leaves charitable donations untouched, except for increasing to 60% the amount of income which can be offset by cash donations, while eliminating entirely the deduction for any amount which entitles you to purchase athletic tickets.
Medical expenses – Under pre-TCJA law, individuals can deduct their unreimbursed medical expenses, to the extent such exceed 10% of their income. Because of this 10% floor, the deduction only benefits those who have substantial medical expenses relative to their income. Both the House and Senate had originally proposed to repeal this deduction. Instead, they temporarily (2018 and 2019) decreased the threshold to 7.5%.
Alimony – Under pre-TCJA law, alimony is taxable to the recipient and deductible by the payor. Because the payor is typically in a higher tax rate bracket than the recipient, this generally results in a net tax benefit, and such is often factored into the settlement reached between divorcing spouses. For divorce agreements entered into after 2018, TCJA eliminates both the deduction and the income inclusion.
Moving expenses – Currently, employers can exclude from taxable pay reimbursement of qualified moving expenses or the employee can take deduction if not reimbursed. For 2018 – 2025 the exclusion and the deduction are repealed (except for members of the Armed Forces).
Elimination of ACA Shared Responsibility Payment – Republicans have long pledged to repeal the Affordable Care Act (ACA or “Obamacare”). They failed in their attempt to do so directly, but may have indirectly succeeded via a provision in this tax legislation which essentially eliminates (for 2019 and forward) the very controversial ACA provision which required individuals to either maintain health insurance or else pay a penalty with their tax return.
Estate tax – Under current law, an individual can leave up to $5.5 million to his or her heirs tax-free, and a married couple up to $11 million. Amounts above and beyond this (unless left to charity), are subject to an estate tax of up to 40%. Republicans have long pledged to repeal the estate tax, and the House Republicans made good on that pledge in their version of tax reform (basically doubling the exemption effective for 2018, and eliminating the estate tax entirely for those dying after 2023). Complete repeal was a tougher sell in the Senate, however. Ultimately, what passed was a doubling of the exemption amount ($11 million per individual, or $22 million for married couple) for 2018 – 2025, but no repeal of the estate tax.
State Tax Impact
Most states start with Federal taxable income in the computation of state taxable income. In recent years, states have had a tendency to “decouple” from Federal law with respect to provisions that significantly reduce taxable income (e.g. bonus depreciation and the deduction for domestic production activities). It will be interesting to see whether states look to generate additional revenue without increasing the advertised rate by decoupling from those provisions which reduce taxable income, while adopting those provisions of the new Federal law which broaden the base.
The substantial limitation imposed on the Federal deduction for state and local taxes going forward may put pressure on states to cut their taxes (at least for their residents), given that the after-tax cost to their residents of such will now be higher. This may in turn mean states becoming even more aggressive at pursuing revenue from out of state businesses and individuals. Also, states may become more creative in structuring “voluntary donations” in lieu of state income tax (e.g. the Georgia student scholarships program credit) or in the use of entity level taxes (deductible as a business tax) in lieu of taxes on the individual owners of business entities.
Also, with the limitation on deductibility of individual state income tax, state credits like the film credit and low-income housing tax credit are likely be in even greater demand.
Significant Provisions from Earlier Proposals Left out of Final Version
Gain from sale of home – Under current law a couple can exclude up to $500,000 of gain ($250,000 for singles) from sale of home so long as used as primary residence for at least 2 of the preceding 5 years. Both the House and Senate had proposed to change this to require 5 of last 8 years, but such unfavorable change did not make it into the final bill.
Tuition waivers for graduate students – The proposal to tax the value of tuition waivers provided to graduate assistants did not make it into the final legislation.
Private activity tax-exempt bonds – The exclusion from taxable income for interest paid on private activity bonds (including bonds issued to build professional sports stadiums) is left in place. This is very important to the affordable housing industry, which often relies on such bonds to finance the construction of affordable apartments (and without which no 4% LIHTCs could be allocated).
Use of FIFO in determining basis of stock sold – The Senate had proposed requiring use of the FIFO method to determine cost basis of stock sold. This would have greatly limited investor flexibility in determining which shares are sold when holding lots acquired at differing times, and in many cases would have vastly overstated an investor’s true gain. This provision (thankfully) did not make it into the final bill.
Educator’s “above the line” deduction – The House made the mistake of suggesting this deduction of up to $250 for out of pocket expenses for classroom supplies would be repealed, while the Senate suggested instead doubling the amount to $500. Ultimately, it was left at $250.
FICA tip credit – The House proposal to increase to $7.25 per hour the point at which FICA tip credit kicks in and to increase from 8% to 10% of gross receipts the assumed amount of employee tips for food and beverage establishment workers was not included in the final legislation.
Winners and Losers (and the not yet known)
If you believe the PR coming from the Republicans, then everyone on the planet (or at least in the US) is a big winner because this tax legislation will be “rocket fuel” for our economy. At the other end of the spectrum, if you believe the Democrats, then this is nothing but a giant give away for the wealthy and corporations which will produce even greater deficits and ultimately result in our having to make cuts to social programs. As with most things in life, reality probably lies somewhere between the extremes.
Identifying the direct winners and losers (those whose tax liabilities will increase or decrease as a result of the legislation) is difficult enough. Determining the indirect impact is even more difficult. With those caveats, below is my quick attempt at identifying some winners and losers.
- C-corps with significant domestic profit – The centerpiece of the tax legislation is a reduction in the top corporate rate from 35% to 21%. For companies with significant profit from US operations, this is obviously a huge benefit. In fact, this rate reduction is estimated to reduce taxes by roughly $1.3 trillion over the next 10 years. Most large C-corps are typically either publicly-traded companies, US subsidiaries of foreign companies, or owned by private equity firms. To determine the true beneficiaries of the rate reduction, you have to look to whom the ultimate owners are. Anyone who owns publicly-traded stocks (directly or through mutual funds, index funds or retirement plans) obviously benefits via the increased value of these companies, and much of this benefit is probably already reflected in current market prices (as the market has been anticipating a reduction in the corporate rate). Some of this benefit, of course, flows outside the US due to non-US ownership of US corporations, but, arguably, the lower US rate encourages foreign ownership in the US.
- C-corps with significant international activity – Measuring the benefit to US companies with significant international activity is more difficult. In the short-term, these companies may be subjected to additional US tax as a result of the requirement to pay in over 8 years a transition tax due on earnings currently parked offshore. Longer term, however, these companies should benefit from the move to more of a territorial system.
- Owners of certain flow-through entities and sole proprietors – Owners of flow-through entities and sole proprietors whose taxable income is below the “threshold amount” ($157,500 for singles, $315,000 for couples, and with a phase-in up to $50,000 more for singles and $100,000 more for couples) and those who own businesses other than “specified service businesses” regardless of income level are huge winners. In addition to the tax rate reductions which will be enjoyed by most individuals, members of this lucky group get a deduction of up to 20% of their “qualified business income”, which will substantially reduce their effective tax rate.
- Successful professionals and executives – Accountants, lawyers, doctors, wealth managers, consultants, and similar professionals with income above the “threshold amount” are denied the 20% pass-thru deduction available to all other businesses, and there is no similar deduction for W-2 employees. Publicly-traded companies will generally not be able to take a tax deduction for amounts paid to top executives in excess of $1,000,000 per year, and nonprofits will owe an excise tax of 21% on executive compensation in excess of $1,000,000 per year, which may put downward pressure on the compensation of top executives. The reduction in the highest marginal rate from 39.6% to 37% will provide some benefit to successful professionals and executives, but those in high tax states or with significant investment expenses may find that the limit on the deduction for state and local taxes and the repeal of miscellaneous itemized deductions more than offsets this benefit.
- High income individuals in high tax states – Most residents of states which have an income tax below 7% will find that their reduction in marginal Federal rate will at least offset the loss of the benefit of deducting state income tax. However, high income individuals in high tax states will likely find that the tax cost of loss of deduction for state and local tax exceeds the benefit of the Federal rate cut.
- Businesses with a tax loss – In the past, when a business suffered a loss the ability to carry the loss back and recover tax paid in an earlier year was often a lifeline for the company (or its individual owners, in the case of a flow-through entity). Going forward, that option is not available.
- Highly leveraged companies – The 30% of adjusted taxable income limit on business interest expense deduction will hurt highly leveraged companies.
- Residential real estate – The increase in the standard deduction (negating the benefit of the mortgage interest and real estate taxes deduction for many), the $750,000 cap on mortgages for interest deductibility (down from the current $1.1 million), and the limit on deductibility of real estate taxes could hurt the residential real estate market.
- Marriage penalty – Several provisions in TCJA (e.g. the tax rate tables, the $10,000 limitation of deduction of state and local taxes, and the $750,000 mortgage cap) potentially favor two individuals remaining single rather than marrying.
- Effective dates and sunset provisions – While the corporate changes were generally made “permanent” (at least until another Congress decides to change them again), in order to comply with Senate rules regarding increases to the deficit, most of the individual provisions have a sunset date. Also, provisions with a delayed effective date (e.g. the requirement to begin capitalizing and amortizing R&D beginning in 2022) are likely to slip up on some taxpayers.
- Simplification – Individuals with fairly straightforward situations (e.g. W-2 income only) with itemized deductions below the standard deduction level may find their income tax situation simpler. However, businesses and individuals with more complex situations (e.g. investments in flow-through entities) will likely find their tax planning and reporting even much more complicated going forward.
- The political process – When the Democrats were in control, they forced through the Affordable Care Act with no Republican support. Now that the Republicans are in control, they have similarly forced through significant tax legislation with no Democratic votes. This does not seem to be a healthy way to legislate.
- The deficit – TJCA will add an estimated $1.5 trillion to the deficit. I am no economist, but it seems to me that deficits do matter, and someone eventually has to pay for them. It seems to me that government should strive to operate at a surplus when the economy is doing well, and save deficits for the recessions when government spending is needed to get the economy going again.
- The law of unintended consequences – Perhaps the biggest losers will be victims of the law of unintended consequences. Given the breadth of this legislation, and the haste with which it was passed (and especially the various adjustments made at the last minute in order to accommodate special interests while staying within Senate budget rules), it is inevitable that there will be some unintended hiccups arise. I dread being the bearer of bad news when they do.
Not Yet Known:
- The U.S. economy – Republicans believe this tax legislation will be rocket fuel for our economy. Time will tell.
- The Republican party – The Republican party has staked its future on tax legislation which, according to polls, is mostly unpopular. The 2018 midterm elections may tell us a lot about whether this was a good gamble.
Actions to be Taken (or Not Taken) Now
Defer income and accelerate deductions – Most corporations and individuals will be in a lower rate bracket for 2018 than 2017. This is particularly true for C-corps and owners of pass-thru entities in favored industries. Also, many individuals who itemize deductions for 2017 will likely be taking the standard deduction for 2018. Accordingly, deferring income to 2018 and accelerating deductions into 2017 will likely result in a permanent tax savings.
Pay state income tax and miscellaneous itemized by year end – For individuals, the deductions for state and local income taxes and miscellaneous itemized deductions (e.g. investment expenses and tax preparation fees) are gone after 2017 (except for $10,000 of state income tax or property tax). Accordingly, assuming that you are not in the alternative minimum tax (AMT), payment of these expenses by the end of 2017 could result in a permanent tax savings north of 40 cents on the dollar (depending in part on your state rate). If you are in the AMT for 2017, you will not enjoy a Federal savings from paying these items by the end of the year, but you may still enjoy a permanent state tax benefit.
Convert to C-corp status? With the C-corp Federal rate dropping to 21%, the question we are getting from many of our S-corp and LLC clients is whether they should convert to C-corp status. To the extent that it was a close call before, the big drop in the C-corp rate may certainly tip the scales in favor of C-corp status. However, while each situation is unique and needs to be carefully analyzed, I suspect that most privately-held companies will be best served to remain as flow-through entities. Assuming an average state rate of 6%, when you factor in the second level of tax on C-corp dividends (including the 3.8% Medicare tax), at higher income levels the combined corporate and shareholder level taxes are about 48%, versus about 44% for a pass-through entity receiving no benefit from the new 20% deduction, and only about 36% if the pass-through owner receives full benefit of the new special 20% deduction. In order to make the math work in favor of C-corp status, you have to retain a significant amount of the profit in the company and be confident that you will eventually exit via a stock sale (avoiding at least one of the two levels of tax upon exit) rather than an asset sale or plan to hold the shares until death (and, hopefully, enjoy a basis step up to date of death value). Special rules (which have not been very relevant in recent years, but may become relevant again) exist to discourage the accumulation of earnings in C-corps beyond the reasonable needs of the business or from using a C-corp as a personal holding company. Further, if the Democrats regain control of Congress and the White House, they may seek to raise the C-corp rate, and the conversion from pass-through status to C-corp status is essentially a one-way street (i.e. generally tax-free to convert to C-corp status, but generally taxable to go back either upon conversion or potentially upon later sale of assets via the “built-in gains tax”). A conversion to C-corp status can be done prospectively at any time, and in some cases retroactively for up to 75 days, so don’t rush into this conversion. Careful analysis and a very long-term view are in order here.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.
1 The official name of the legislation is “An Act to provide reconciliation pursuant to titles II and V of the concurrent resolution of the budget for fiscal year 2018”. The Tax Cuts and Jobs Act title was found not to be acceptable under Senate rules without 60 votes in favor, since tax legislation requires 60 votes in favor under Senate rules, whereas budget reconciliation legislation requires only 51 votes in favor.