By Michael Silvio, Tax Director, Hall & Company CPAs and Consultants
The Tax Cuts and Jobs Act was signed and enacted on Dec. 20, 2017 after a lengthy and sometimes controversial set of negotiations and debates. The broad legislation tackles corporate and individual tax policies to varying degrees – some small revisions and some sweeping overhauls. To help make sense of it all, we highlighted some of the more notable policy changes.
A new “pass-through” deduction is available for taxpayers who are not C-Corporations. The deduction is generally 20% of a taxpayer’s “qualified business income” (QBI) from a business within the USA. Certain types of investment-related items are excluded from QBI, such as capital gains or losses, dividends and interest income (unless the interest is properly allocable to business activities). Employee compensation to shareholders in an S corporation and guaranteed payments made to a partner in a partnership are also excluded from QBI. For S corporations and partnerships, the deduction is taken at the partner/shareholder level.
A qualified trade or business is any trade or business other than a specified service trade or business. A specified trade or business involves the performance of services other than engineering or architecture. There are other limitations that may affect the calculation of the 20% deduction.
Taxpayers including service businesses described above with taxable income below $157,500 ($315,000 joint filers) are not subject to the various limitations.
Business expensing of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 will be subject to 100% first year depreciation and is no longer limited to just new equipment. Code Sec. 179 expensing for small businesses increased to $1 million with the phase-out amount increased to $2.5 million. Additionally, the legislation expands the definition of qualifying property under Code Sec. 179 to include heating and cooling systems, certain lodging expenditures and improvements to property. Like-kind exchanges are limited to real property that is not held primarily for sale (no more personal property tax free exchanges).
New disallowance of deductions for net interest expense in excess of 30% of the business’s adjusted taxable income (exceptions apply). The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely and utilized in future years, subject to this and other applicable interest deductibility limitations.
Notably, the bill expands the use of the cash method of accounting for taxpayers with average annual gross receipts that do not exceed $25 million for the prior three years (up from $10 million average). Taxpayers meeting the $25 million threshold are not required to account for inventories under Code. Sec. 471 and may be exempt from the application of the UNICAP rules.
Other business provisions include reducing the federal tax rate for C-corporations from 35% to 21%, repealing the deduction for the Domestic Production Activities (DPAD) and disallowing entertainment expenses other than business meals. The corporate alternative minimum tax (AMT) is repealed as well as the 10% rehabilitation credit (the 20% credit is retained). Employers can claim a new credit for wages paid to qualifying employees that are on Family and Medical Leave (FMLA). Regarding net operating losses (NOL), the two-year carryback and the 20-year carryforward have been repealed for NOLs arising in a taxable year ending after December 31, 2017. Instead, NOLs will be carried forward indefinitely. An income limitation also applies under the new law that limits the amount of NOL that a can be deducted in a single year to 80% of the taxable income.
U.S. International Tax Reforms
For years after December 31, 2017, the new tax reform act implements a “participation exemption”, whereby U.S. C-Corporations can deduct 100% of foreign-source dividends received from foreign corporations in which they own 10% or greater of, for more than one year. The foreign corporations cannot be considered passive foreign investment companies (PFICs) and the U.S. C-Corporations also cannot be classified as regulated investment companies (RICs) or real estate investment trusts (REITs). U.S. S-Corporations, partnerships and individual taxpayers do not qualify for the “participation exemption”. Because of this new territorial-style system being established, there is no longer foreign tax credits or deductions allowed for foreign taxes attributable to such foreign source dividends.
Prior to January 1, 2018, post-1986 accumulated earnings and profits (E&P) in foreign corporations, in which U.S. shareholders own at least 10% or greater, must be included in U.S. taxable income beginning with tax years after December 31, 2017. Repatriation of accumulated E&P is deemed, even if actual dividends are not paid to U.S. shareholders, because the new rules mandate Subpart F inclusion of the E&P in the year before U.S. shareholders transition to the new territorial system. The inclusion amount can be reduced by any aggregate foreign E&P deficits, and it appears that a partial deduction is allowed so that a U.S. shareholder’s effective tax rate is 15.5% on the “aggregate foreign cash position” and 8% otherwise. U.S. shareholders can elect to spread the net federal tax liability over a period of up to eight years, according to the following schedule:
- 8% of the net tax liability in the case of each of the first five installments,
- 15% of the net tax liability in the case of the sixth installment,
- 20% of the net tax liability in the case of the seventh installment, and
- 25% of the net tax liability in the case of the eighth installment
Special rules also apply in such cases for individual shareholders of S-Corporations, RICs and REITs.
There are several other provisions of the new tax reform act, related to U.S. international taxation, which are not addressed here. However, it appears likely that the growing enforcement in U.S. international tax compliance over the past few years will continue, and possibly expand, under the new tax regime as FATCA reporting becomes implemented with full effect both within the U.S. and globally.
A new rate structure for individual income tax rates will take effect through 2025. The new structure includes seven tax rates:
- 10% for taxable income under $9,525 single or $19,050 joint
- 12% for taxable income under $38,700 single or $77,400 joint
- 22% for taxable income under $82,500 single or $165,000 joint
- 24% for taxable income under $157,500 single or $315,000 joint
- 32% for taxable income under $200,000 single or $400,000 joint
- 35% for taxable income under $500,000 single or $600,000 joint
- 37%for taxable income over $500,000 single or $600,000 joint
The tax rates and income thresholds for married filing separate and head of household has also changed.
Notable for families, the child tax credit increased to $2,000 with the refundable portion limited to $1,400. The bill also includes a new nonrefundable credit for certain non-child dependents of $500. The phase-outs for these credits start at $200,000 for single filers and $400,000 for joint filers. The new policy also eliminates the alimony deduction by payor/inclusion by payee for all divorce agreements signed after December 31, 2018. Those in affect prior to this date are grandfathered in and will continue to be treated as a deduction on the payor side and income on the recipient side.
The capital gains tax retains rates of 0%, 15% and 20% with 15% rate applying to $38,600 for single filers and $77,200 for joint filers. The 20% rate will apply to $425,800 for single filers and $479,000 for joint filers.
Elimination of the moving expense deduction (with an exception for members of the military in certain circumstances) — through 2025. For an eight-year period starting in 2018, most employees will not be able to exclude qualified moving expense reimbursements from income or deduct moving expenses.
Various changes to itemized deductions and exemptions include:
- The medical expense deduction threshold is temporarily reduced to 7.5% of adjusted gross income retroactively back to January 1, 2017.
- The state and local tax deduction is capped at $10,000 (inclusive of property taxes).
- The mortgage interest deduction limit now drops to $750,000 for new mortgage debt after December 15, 2017, including second homes. Additionally, interest on home equity loans other than a limited amount that was used to acquire or improve a qualified residence is no longer deductible.
- The charitable contribution deduction limitation increased from 50% to 60% of adjusted gross income.
- Gambling loss limitation is broadened to include any expense incurred in gambling, not just gambling losses.
- Miscellaneous itemized deductions such as investment fees and expenses, tax preparation fees and unreimbursed employee business expenses are suspended.
- The 3% limitation on certain itemized deductions has been eliminated. Itemized deductions are no longer subject to the 3% of taxable income limitation over $261,500 for single and $313,800 for married.
- The standard deduction has been doubled to $12,000 for single filers and $24,000 for joint filers with adjustments for inflation.
- Personal and dependent exemptions ($4,050 per exemption) have been eliminated.
- New exemption amounts for alternative minimum taxable income (AMTI) are $70,300 for single filers and $109,400 for joint filers with phase-out amounts of $500,000 and $1 million, respectively. Without state tax deductions or miscellaneous itemized deductions
Regarding retirement accounts, the policy maintains 401(k) and IRA deduction limits but drops Roth IRA recharacterization for Roth conversions. If you are 70½ or older but your donations do not bring you over the new higher standard deduction, you can make those donations directly from your IRA as a custodial transfer.
The legislation preserved the estate tax and doubled the estate and gift tax exemption from $5 million to $10 million. The $10 million amount is indexed for inflation and is expected to be approximately $11.2 million in 2018 ($22.4 million per married couple).
The legislation also repealed the individual mandate under the Affordable Care Act after 2018.
Expansion of tax-free Section 529 plan distributions to include those used to pay qualifying elementary and secondary school expenses, up to $10,000 per student per tax year.
Next steps – The overall effects of the changes in the tax law will vary among taxpayers. We can expect more guidance from Congress in the near future so that we are able to better inform you and plan effective strategies to reduce your overall tax burden.