Tax Reform is Almost Here: Here’s How to Plan for it

The first major American tax reform since 1986, the Tax Cuts and Jobs Act (TCJA) of 2017 is almost here. As of this writing the House has approved it and we are waiting for the Senate to act. Once it does, the Bill will be sent to President Trump who will sign the Bill into law, expected before Christmas.

What does the largest overhaul of the tax code in a generation mean to you and how does it affect your planning? While this is a highly complex and voluminous law not 100% finalized we do have a pretty good idea what it’s going to say so read on for first impressions!

 Changes to the Income Tax Brackets

 Under the new law, the individual Tax Brackets are set at 10%, 12%, 22%, 24%, 32%, 35% and 37%.

 What this means for your planning

You and your advisors should quickly review what marginal bracket you will be in for 2017 vs 2018. This may impact the advisability of deferring income or accelerating deductions depending on which year will provide the greatest benefit.

 Personal Exemptions and Standard Deductions

The new Law eliminates deductions for personal exemptions while increasing standard deductions to $12,000 for single filers and $24,000 for married, joint filers. The following, well known, itemized deductions are being modified or eliminated:

 ·      The deduction for state and local income, sales and property taxes is capped at $10,000.

·      The deduction for mortgage interest is reduced, and only allowable on up to $750,000 of acquisition indebtedness (note that mortgages incurred on or before December 15, 2017 are grandfathered and thus still allowed $1,000,000.00 of acquisition indebtedness).

·      The home equity interest deduction is repealed.

·      Taxpayers will be allowed to deduct Medical expenses if they exceed 7.5% of adjusted gross income (instead of 10%) for tax years 2017 and 2018.

What this means for your planning

Be mindful of how the loss of personal exemptions affect your taxable income. For those of you that are used to deducting sizeable state and local income taxes, work with your advisors to determine if accelerating the payment of state and local tax liabilities makes sense.

 Those no longer allowed to deduct state income taxes should speak to their advisors about alternative solutions to avoid or mitigate state income taxes.

 If possible, you may wish to accelerate medical expenses into 2017 and 2018 to take advantage of the lower 7.5% of AGI limitation.

 Charitable Income Tax Deductions

 The new law increases the charitable contribution limit to 60% of AGI for cash contributions, while keeping the limit on contributions of appreciated property at 30% of AGI.

 What this means for your planning

If you will no longer itemize you may wish to consider a contribution to a Donor Advised Fund before the end of the year where you can make a charitable contribution and receive an immediate tax benefit.

 Individual Alternative Minimum Tax (AMT)

The AMT exemption is increased to $70,300 for single filers and $109,400 for married joint filers. The thresholds for the phase-out of the AMT exemptions is increased to $500,000 for single filers and $1,000,000 for married joint filers.

 What this means for your planning

Those of you with Incentive Stock Options should consult with your advisors to time the exercise of these options in years they are not subject to AMT due to higher exemptions.

 Estate Tax

TCJA does not repeal the estate tax as was proposed in the House version, however it doubles the estate, gift, and GST tax exemption amounts from $5 million to $10 million, adjusted for inflation. The 2018 Unified Exemption will be $10,600,000.00 per person. It also provides for increases to the exemptions based on inflation. The exemption sunsets after 2025.

 What this means for your planning

With the exemption set this high most families will not be affected by a ‘death tax’ however for those that are it is an enormous tax bite at 40%! This can easily destroy a closely held business or large family farm – and for those affected it will definitely undermine family legacy goals! This means planning is still critical for families with large, closely held businesses or those that have a net worth significantly greater than the exemption amounts.

 Considering that, barring further Congressional action, the exemption amounts will revert back to $5 million in 2026 planning now while the gift tax exemption is doubled for the next several years may be crucial. Make sure to discuss these matters with your advisor!

 Clients who purchased life insurance to finance the payment of estate and other taxes and expenses should think carefully before cancelling or reducing coverage. If your estate does not now nor is ever likely to exceed the inflation-indexed exemption amount(s), using the new-found exemption amounts to “un-wind” life insurance premium financing and note sale transactions may be attractive. Making large gifts to ILITs that have dynastic provisions could also be worth exploring.

 Estate tax planning is still required for those states that have decoupled and instituted their own state estate tax. In many cases, the state exemption may be significantly lower than the federal amount.

 Business Income Tax Changes

Unlike the changes affecting personal income tax, most of the changes affecting Business Income are permanent.

 Corporate Income Taxes

The corporate income tax is reduced to 21% and corporate alternative minimum tax is repealed. 

What this means for your planning

Premiums on corporate owned life insurance should be lower while death benefits received by a corporation from a life insurance policy it owns may be more effective. All arrangements involving corporate payment of life insurance premiums should be reviewed.

Pass-Through Businesses

TCJA provides for a 20% deduction on non-wage portions of pass-through income (down from 23%) on “Qualified Business Income.” In practice this means that pass-through businesses (partnerships, LLCs, S corporations, and sole proprietorships filing a Schedule C) will be effectively taxed on only 80% of their pass-through income - or put another way – on only 80% of their normal rate on all business income!

What this means for your planning

Planners and business owners will need to revisit how a client’s business should be structured and operated and reevaluate the pros and cons of pass-through entities in the light of the Law dropping the C Corporation rate to 21% and changing the long-standing approach of taxing pass-through business income at individual tax rates. Numerical comparisons are essential!

 You should talk to your advisor about finding the lowest tax bracket party to pay for needed life insurance, and about split dollar life insurance to remove equity out of a business while minimizing current income tax.

 The step up in basis is retained so assets held in your taxable estate at death will receive a new stepped up tax basis. This is very valuable especially in the high tax taxes like NY, CA, IL and HI, so make sure you do the math before moving your low basis appreciating assets out of your estates. Careful planning and flexible dynasty trusts, like the HYCET Trust will be vitally important.

 Other Tax Provisions

TCJA contains many other provisions. The following is a brief summary of some of them most relevant to those reading this Client Alert:

?      Full expensing of investments in new depreciable assets made after September 27, 2017 and before January 1, 2023 will be permitted.

 ?      There is a 20% per year phase-down of the full expensing for property placed in service after December 31, 2022 and before January 1, 2027.

 ?      The limit on section 179 deductions wherein businesses can deduct the full purchase price of qualifying equipment and/or software purchased or financed during the tax year is increased to $1 million.

 ?      Deductions for certain fringe benefits, such as business entertainment expenses, have been limited.

 ?      Net operating loss (NOL) deductions are limited to 80% of pre-NOL taxable income. There is an indefinite NOL carryforward, but no carryback to prior years for most companies.

 ?      A three-year holding period is required for a carried interest to qualify as a long-term capital asset.

 ?      The itemized deduction for personal casualty losses would be restricted to losses incurred in a presidentially declared disaster area. This sunsets after 2025.

 ?      Tax preparation fees are no longer deductible. This sunsets after 2025.

 ?      Except for members of the Armed Forces moving expenses are no longer deductible. This sunsets after 2025.

 ?      Reversing or re-characterizing a Roth IRA is no longer permitted.

 ?      The penalty for failing to maintain minimum health care coverage is effectively eliminated starting January 1, 2019.

 ?      529 Plans can be used for K-12 schools and for homeschooling.

 ?      The alimony deduction for the payor ex-spouse and the inclusion of alimony in gross income of the recipient ex-spouse is repealed for any divorce or separation instrument executed or modified after December 31, 2018.

Conclusion

We are one step away from the first major tax change since 1986. It may be years before the broader ramifications of TCJA are known but it is fairly certain to impact most all Americans.

Be that as it may, much remains to be seen. Will the new law result in meaningful higher wages, new jobs and business growth? Will it help middle or lower income Americans to any meaningful extent? Will it dangerously increase the deficit? Will it weaken social safety nets?

 What is certain is that in the end whatever is done can be eventually undone when the political climate changes. Most of the provisions affecting individual, as opposed to corporate, taxpayers sunset after 2025, and if the other party is in power at that time, you can most predictably expect the lower tax provisions not to be extended. Accordingly it seems safe to say that none of this is will be “permanent,” as permanent fixes are never permanent so long as future Congresses can make changes. This is why executives, professionals, business owners, high income and high net worth individuals and families will always benefit from planning advice and expertise to understand their options.