A Deeper Dive into Proposed Tax Cuts

I was hesitant to dive to further into the proposed individual tax reforms under the republican tax plan (“Tax Cuts and Jobs Act”), given that it’s not law yet and so much of what we know so far may ultimately change.

One thing that is clear is that corporate tax reform is the centerpiece of the republican plan with the emphasis on lowering the corporate tax burden and simplifying the code in the hope that corporations will spend more money to create more jobs in the United States and this will result in higher wages for workers.

On the individual side, we also received a clearer framework last week on key changes and there is a clear emphasis on simplifying the current tax filing process.

Individual Income Tax Brackets

Individual tax brackets are proposed to be reduced from seven to four – 12%, 25%, 35% and 39.6% (although it’s really five as there is a special surtax bracket of 45.6% that applies to income between $1 – $1.2 million (filing individually) and $1.2 – $1.614 million filing jointly).

The old 10%, 15% brackets and a small slice of the 25% brackets are replaced with a 12% bracket for income up to $45,000 (individuals) and $90,000 (married filing jointly), resulting in a small tax cut for most affected.  The old 25%, 28% and a small slice of the new 33% brackets are being replaced with a 25% bracket applied to individuals making up to $200,000 (individuals) and $260,000 (married filing jointly), similarly resulting in a small tax cut for most affected.  The old 33%, 35% and a slice of the 39% brackets are effectively combined into the new 35% bracket for income up to $500,000 (individuals) and $1,000,000 (married filing jointly).  The impact here will be a 2% increase for those under $416,700 of income (the old 33% threshold) and a 4.6% decrease for those who were previously in the 39.6% bracket (below the new $500,000 and $1,000,000 thresholds).  If your income exceeds this amount, then call us if you want more detail on the new surtax.

The new brackets will be indexed for inflation going forward using the slightly lower CPI-U vs. headline CPI and all the brackets would apply for the 2018 tax year (and not 2017).  Importantly, the Alternative Minimum Tax is proposed to be repealed entirely.

Capital Gains and Qualified Dividends

The long term capital gains and qualified dividends thresholds and rates will remain as they are under the existing system.   This effectively means that the 0%, 15% and 20% capital gains bracket remain tied to the old seven tax brackets, not the new ones.  The 0% rate will apply to incomes up to $51,200 (individuals) and $77,200 for married couples.  The 15% bracket will apply to incomes for individuals with income up to $425,000 and $479,000 for married couples.  The 20% bracket will apply to taxpayers with income exceeding $425,000 and $479,000, respectively.  The 3.8% Medicare surtax, which is tied to individuals earning $200,000 and those married (filing jointly) earning $250,00 or more, is also proposed to remain, effectively creating two additional brackets of 18.8% and 23.8%.

Expanded Standard Deduction and Child Tax Credits

Beginning with 2018 tax filing, the existing standard deduction ($6,350 individuals; $12,700 couples) and the personal exemption ($4,050 per person) are to be combined into a single standard deduction of $12,000 for individuals and $24,00 for married couples.  This will certainly simplify things and result in an increase tax saving for most taxpayers.  Larger families, however, will receive less with the elimination of the personal exemption.  This is proposed to be mitigated by the increase in the child tax credit (from $1,000 to $1,600) and a new $300 “Family Flexibility Credit” that applies to non-child dependents (college age children and elderly parents).  These new credits phase out in 2023, however, and both the child tax credit and Family Flexibility Credit phase out for individual with incomes from $75,000 to $115,000 and families with income from $110,000 to $230,000.

The elimination of the personal exemption also means that the Personal Exemption Phaseout (PEP) is repealed.

The net result of these changes is that most families will see a tax savings with the new rules versus the old rules.  It’s estimated that fewer than 10% of households will itemize deductions going forward, compared to approximately 33% today.

Itemized Deductions

With an emphasis on “simplifying” the tax code, there is major effort to curtail tax preferences (deductions and credit).  The goal is to make itemizing a moot point for the majority of taxpayers and offset the loss of deductions with slightly lower tax brackets for most and the expanded standard deduction.

With that said, the elimination of certain deductions and credits as proposed are quite material for those who currently itemize and are directly affected by them.

As proposed, individuals would no longer be able to deduct state and local income taxes (SALT) beginning with their 2018 tax filing (2017 remains as-is).  These deductions would be eliminated entirely going forward.

The deduction for “real” property taxes (i.e. real estate) for both individuals or those married filing jointly would be capped at a maximum of $10,000.   The deduction would not apply to “personal property taxes” in certain states that have them.

The medical expense deduction is repealed.  While this impacts few households, those that it does will be especially impacted.

The mortgage interest deduction is one of the most popular deductions and one of the most expensive for the federal government and thus a target of tax reform.  Going forward the mortgage interest deduction will be cut in half and permitted on mortgage debt up to $500,000 and only on a primary residence (no longer for second/vacation homes).  To be deductible, only interest on “acquisition indebtedness” – debt borrowed to acquire, build or substantially improve a primary residence would be deductible while so-call “home equity indebtedness” (not “acquisition indebtedness) would no longer be deductible.

The charitable deduction essentially remains the same with slight changes.  On a positive note, the deduction for cash contributions to a public charity would now be limited to 60% of adjusted gross income (AGI) compared to 50% under current rules.  On the negative side, all donations must have a written acknowledgement (as opposed to only donations exceeding $250.00 under current rules).

The deduction for casualty losses is repealed (except as specifically authorized by Congress for special disaster relief) and the deduction for gambling losses (tightened slightly to be limited only to the extent of gambling winnings) remains.

With the overall curtailment of itemized deductions, the current Pease limitation on itemized deductions (which phases out itemized deductions by 3% of the excess above AGI of $161,500 for individuals and $318,800 for couples) is also repealed.

While the proposed changes do not entirely eliminate the category of Miscellaneous Itemized Deductions subject to the 2% AGI floor, the elimination of the aforementioned deductions will make it that much harder to capture these deductions.  Among this group, the deduction for tax preparer expenses and moving expenses to a new job are eliminated and the deduction for investment advisory fees is retained.  The Plug-in Electric Motor Vehicle Credit of $7,500 is repealed as it the Adoption Tax Credit (up to $13,750 per child).

Alimony Payments

For new alimony agreements entered into after 2017, the income tax deduction for the payer is eliminated and payments to those receiving alimony would no longer be taxable, which simplifies this provision and effectively eliminates scenarios where tax savings were achieved by a divorced couple (where the payer was in a higher bracket and the recipient was in a lower bracket).

Capital Gains Exclusion on Sale of Primary Residence

The current rule allowing the exclusion capital gains on the sale of a primary residence ($250,000 for individuals and $500,000 for married couples) required that sellers used the property for at least 2 of the last 5 years.  This rule is deemed to be abused by “house flippers” and so the requirement will be changed to “5 of the last 8 years” (unless the residence is being sold due to a change in the place of employment, health or other “unforeseen circumstance”).  In addition, the exclusion will be further limited with an income test, which phases out the exclusion by $1 for every $2 above an AGI of $500,000 for couples and $250,000 for individuals.

Elimination of Various Employee Fringe Benefits

Dependent Care Assistance Programs, Qualified Moving Expense Reimbursements, Adoption Assistance Programs, Employer Provided Child Care Credits, Employer Provided Educational Assistance, Qualified Tuition Reductions for Employees of Educational Institutions are all repealed.  The Meals and Entertainment Expense is limited to 50% for food and beverage only and Employer Provided House Exclusions are limited to a maximum value to $50,000 and phased out for AGIs exceeding $120,000.

Educational Planning Reforms:  529 Plans and American Opportunity Tax Credit

The Hope Scholarship Credit and the Lifetime Learning Credit and the above the line deduction for tuition and related expenses are repealed and consolidated into the American Opportunity Tax Credit (AOTC), which will continue to provide a 100% tax credit for the first $2,000 of educational expenses and a 25% credit on the next $2,000 of expenses ($2,500 max credit).  The AOTC is also expanded from four years to cover a fifth year of college (graduate school) at 50% of the otherwise available rate.  This was long overdue as virtually all taxpayers claimed only the AOTC anyway and so these changes actually make sense and make things simpler/less confusing.

Coverdell Education Savings Accounts will not be permitted after 2017.  Existing Coverdell accounts won’t need to be eliminated and new rules will allow them to be rolled over to 529 plans.  The appeal of Coverdell accounts was that they permitted tax-free distributions for elementary and high school expenses whereas 529 plans do not.  To resolve the disparity, tax-free distributions of up to $10,000/year from 529 plans for private elementary and high school expenses (and certain apprenticeship programs) will be permitted beginning in 2018.

529 plans will also now be allowed for unborn children in utero.  How to fill out a 529 plan application without the child’s social security number is yet to addressed as are the implications of recognizing unborn children for tax purposes!

Preferential 25% Tax Rates for Business Income from LLCs and Partnerships

The plan proposes that income from a “pass-through-entity” – e.g., a partnership, LLC or S Corporation will be subject to a 25% maximum rate, which has created a lot of “buzz” for small business owners.

The reality of the proposal is that not all pass through income will qualify.  For personal service businesses (consultants, lawyers, accounts, engineers, performers, financial services providers), there will be no benefit as their income will not be treated as “25% business income” and will instead be taxed as ordinary income.  This will curtail high income earners from becoming independent contractors and providing services back to former employers.

Any pass-through business income derived from a passive activity (where passive is generally defined based on whether the owner ‘materially participates in the business for at least 500 hours per year’) will automatically be characterized as 25% income.  This will benefit investors in real estate or other limited partnerships (where there is no material participation) and which will automatically be eligible for the 25% rate.

In the case of an “active” business owner, they must split their income between income derived from their labor (taxable as ordinary income) and income derived from their capital contributions (eligible for the 25% rate).  The allocations and calculations here are the subject for another piece.  Notably, any salary or guaranteed payments assigned to owners will automatically be treated as labor income.

Roth IRA Recharacterizations Repealed

The rules permitting the recharacterization of a Roth IRA contributions and Roth IRA conversions would be repealed beginning in 2018.  The targets here are those who convert and invest and wait to see if the market performs well (or not) before deciding to keep the conversion (and pay income taxes) or reverse it (recharacterize).  The new rule makes conversion irrevocable and merits more caution.  It also limits the ability to convert the “perfect” amount to fill up lower tax brackets (by converting more than enough and then recharacterzing the excess).

Notable and Miscellaneous

Archer Savings Accounts (MSAs) are repealed, but this is ok as Health Savings Accounts (HSAs) are still good and MSAs can be rolled into HSAs going forward.

Private Activity Municipal Bonds issued after 2017 will be fully taxable as ordinary bonds and no longer eligible as tax-free municipal bonds (which results in similar treatment given current AMT rules).  Importantly, existing private activity municipal bonds already issued will remain tax-exempt.

Nonqualified Deferred Compensation will be more restricted and must truly be subject to risk of substantial forfeiture to defer income taxes.

Estate and Gift Tax Exemption

Beginning in 2018, the estate and gift tax exemption would be doubled from the currently projected $5.6 million to $11.2 million ($22.4 million per married couple).

The estate tax would be repealed completely in 2024 along with the generation skipping tax.

The gift tax, however, would remain at the $11.2 million level ($22.4 million per couple) adjusted for inflation, along with the $15,000 gift tax annual exclusion ($30,000 per couple), adjusted for inflation.  The gift tax rate would be reduced to 35%, from 40%, when the estate tax exemption is repealed.

The “step-up in basis” at death would also remain, even after estate tax repeal.

To summarize, the proposed framework provides a clearer picture of the key changes on the table and it’s clear that, as proposed, it will simplify the tax filing process.

Individuals would be reduced to four tax brackets (almost all individuals) and most would claim just a few itemized deductions (property taxes, mortgage interest and charitable).  With the higher standard deduction, 90% of taxpayers are not expected to itemize at all.  Miscellaneous tax credits popular with very small bases of constituents would be repealed as well and bona fide reform of tax credits for college expenses and tax preferences for educational savings in general would also be accomplished.

Ultimately, whether the Tax Cuts and Jobs Act (TCJA) is actually passed remains to be seen as does the extent to which the current proposals remain intact or end up being altered in the bargaining process necessary to pass it into law.

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