It is clear that the 2017 Tax Act1 is significant and provides numerous fundamental changes that make our already complex tax system even more complex. With this level of complexity, it is likely that it will take several years for tax professionals to fully understand its terms and the planning needed to fully benefit from these changes.
The purpose of this installment of The Passionate Estate Planner is to both review the 2017 Tax Act and provide our thoughts on the practical meaning of these changes. Please be aware that the 2017 Tax Act is massive, and we are only reviewing the changes we felt were most interesting, but without covering the foreign tax changes which are highly complex and have less applicability.
Article Quick Reference Guide
- General Comments
- Individual Income Taxation
- Income Taxation for Businesses
- Alternative Minimum Tax (AMT)
- Wealth Transfer Taxes
- Effective Dates
- Indexing Formula Being Changed
- Personal Income Tax
- The Changes Enabling Most Individuals to Pay Less Income Tax but Also Causing Uncertainty for Many
- Planning Considerations
- Child and Other Qualified Dependent Tax Credits
- Kiddie Tax
- Taxation of Alimony
- Obamacare Taxes
- 529 Plan Accounts
- Other Misc. Personal Income Tax Changes
- Business Income Tax
- C Corporation Tax Rates
- 20% Deduction on the Taxation of Qualified Business Income from Pass-Through Entities (IRC Section 199A)
- Planning Considerations
- Other Misc. Changes
- Wealth Transfer Taxes
1. General Comments
A. Individual Income Taxation
One of the initial selling points of the 2017 Tax Act was touted as simplifying income taxation. While this objective was achieved for many, it failed miserably for others. As for any particular taxpayer paying more or less in income taxes, time will tell. However, the current best guess is that most will pay less, while some others will pay more, at least until the individual income tax changes sunset at the end of 2025. We can say that many at lower income levels who used to file, will no longer need to file, and others with somewhat more income will have an easier time preparing their tax returns. On the fairness front, the marriage penalty was significantly reduced.
B. Income Taxation for Businesses
This is the area of most significant change and complexity. In order to encourage economic activity, C corporation’s will now be taxed at a much lower, flat 21% rate, pass-through businesses, including sole proprietorships, LLCs, S corporations and partnerships, have the potential to qualify for a 20% deduction on the taxation of business profits (IRC Section 199A), depreciation deductions for most businesses have been significantly improved, some only on a temporary basis and some on a permanent basis, and major changes have been made to the taxation of multinational businesses, along with the requirement and incentive to bring back foreign profits held overseas.
C. Alternative Minimum Tax (AMT)
The AMT has been one of the most complex aspects of our income tax laws. It was believed that the 2017 Tax Act would eliminate the AMT for businesses and individuals alike. However, because of the significant cost, the corporate AMT was eliminated while the individual AMT was retained in a modified manner so that it would have significantly less effect. The personal AMT exemptions were increased to $70,300 for singles and $109,400 for married filing jointly (MFJ). In addition, the personal AMT exemptions would not begin phasing out until taxable income was over $500,000 (single) or $1,000,000 (MFJ). To the extent the personal AMT will still apply to any particular taxpayer is as unknown as usual, especially since many of the deductions that helped cause the AMT to apply prior to 2018 will no longer be available. While not yet clear, it may be that the AMT will have little current effect, but it may be back at full strength after the 2017 Tax Act sunsets after 2025 or it will be waiting to pounce as a stealth tax after other tax changes are made by a future Congress.
D. Wealth Transfer Taxes
The wealth transfer taxes include gift, estate and generation-skipping transfer (GST) taxes. The changes to the wealth transfer taxes were simple and very advantageous, but because of the sunset expected at the end 2025, these changes will also cause complexity and frustration.
Under the 2017 Tax Act, the Basic Exclusion Amount doubles for gift and estate tax purposes from $5 million each, indexed for inflation, to $10 million each, indexed for inflation. In addition, because portability has been retained, a married couple can effectively pass on a combined $20 million, indexed for inflation, assuming the necessary estate tax return is filed within the required time limit after the first spouse’s death. Likewise, the GST tax exclusion doubled from $5 million to $10 million, indexed for inflation. However, as under prior law, GST tax exclusions do not qualify for portability.
The changes to the wealth transfer taxes effectively eliminate any negative tax consequences from these taxes for 99.5%+ of society, other than filing informational tax returns when needed. The change in tax basis to date of death value (commonly referred to as the “step-up in income tax basis” at death) is unaffected, so the income tax benefits from death remain. The only issues, albeit significant, stem from the temporary nature of these changes.
E. Effective Dates
For the most part, the 2017 Tax Act provisions become effective on January 1, 2018. While the business tax changes are mostly permanent, the individual tax changes are mostly temporary and will sunset in 8 years, after 2025, meaning more complexity and uncertainty. We lived with temporary tax laws from 2001 to 2013, and we are now starting this process again.
F. Indexing Formula Being Changed
The 2017 Tax Act makes a permanent change to how various tax figures are indexed for inflation, to slow their increase over time. While the Consumer Price Index (CPI) has historically been used, the government will now use a modified CPI, known as “chained CPI.” The CPI considers the cost of a static basket of goods, whereas the chained CPI also considers that individuals will purchase cheaper substitute goods when prices go up in the static basket. The effect of this change will likely be felt over many years as these tax figures may not be fully keeping up with inflation, at least as compared to how inflation was historically calculated.
2. Personal Income Taxes
A. The Changes Enabling Most Individuals to Pay Less Income Tax but Also Causing Uncertainty for Many
Under the 2017 Tax Act, most taxpayers will see a tax reduction as a result of the following changes: (a) the tax rates for the majority of taxpayers will be reduced; (b) the Standard Deduction is doubled ($24,000 for married filing jointly), while retaining the additional Standard Deductions for the elderly (at least age 65), blind and disabled; (c) the child tax credit (for those supporting dependent children under age 17) is increased and more usable by most taxpayers; (d) a new $500 dependent care credit was added for those supporting individuals who are not dependent children under age 17; (e) the medical expense deduction has been improved for 2017 and 2018 by reducing the Adjusted Gross Income (AGI) floor to 7.5% from 10%; (f) the charitable deduction rules were retained with slight improvement by increasing the AGI limitation from 50% to 60% (but this supposed improvement may have limited practical effect) for cash contributions to public charities; (g) the “PEASE” limitation” that reduced itemized deductions as income increased has been eliminated; and (h) the possible application of the AMT has been substantially reduced.
However, these benefits are at least somewhat, if not fully, offset for many taxpayers by a reduction in other tax deductions and exemptions, including: (a) personal exemptions were eliminated; (b) the total (SALT) deduction for all state and local income, sales and real property taxes is now limited to $10,000; (c) the deduction for mortgage interest on primary and second homes is now limited to the extent of “acquisition indebtedness” up to $750,000 for each home purchased after Dec. 15, 2017, with acquisition indebtedness mortgages in place before this date being grandfathered to come under the prior $1,000,000 limit, but of more importance is the inability to deduct any other home equity loan interest; (d) miscellaneous itemized deductions have been eliminated, which include, for example, tax planning advice, tax return preparation, unreimbursed employee business expenses, and investment advisory fees; (e) moving expense deductions have been eliminated; and (f) the ability to deduct 80% of the contribution made to a university to get seating rights has been eliminated.
B. Planning Considerations
(1) Many more will take the standard deduction rather than itemize deductions.
In general, except for those making significant charitable gifts or for those with significant medical expenses in comparison to their income, most taxpayers will no longer get any benefit from their individual tax deductions since they will total less than the Standard Deduction. However, depending on the reaction of state legislatures, some may end up itemizing even if federal itemized deductions are below the Standard Deduction since the loss of some of the Standard Deduction may be more than offset by the ability to take pre-2017 Tax Act itemized deductions for state income tax purposes.
(2) The charitably inclined may still itemize from time to time.
Except for those with major medical expenses in relation to their incomes, the charitable deduction will be one of the only ways to achieve a significant personal income tax deduction. For the charitably inclined, bunching will be the order of the day. A contribution should be made in one year to cover multiple years to achieve the maximum allowable charitable income tax deduction. The effect will be to itemize in years a large charitable deduction is made and the standard deduction will likely be taken in the other years. Specifically, if able, we recommend contributing appreciated stock, real estate or other long-term capital gain type assets, to a charitable family foundation (such as a donor advised fund). This will enable you to obtain the desired charitable income tax deduction in the year of contribution while deciding how to pass these funds on to the ultimate charities over time. In addition, this strategy will likely enable you to achieve a full fair market value charitable income tax deduction, while avoiding paying income tax on any built-in gain.
(3) Home Equity Loans as Acquisition Indebtedness.
While interest on home equity loans is generally no longer deductible as an itemized expense, it continues to be deductible to the extent the loan proceeds were used to purchase or improve your primary or secondary residence.
(4) Possible Planning Around the Inability to Deduct Itemized Expenses.
As discussed above, many expenses are no longer deductible as itemized deductions. However, it should be noted that this limitation relates to personal expenses, and not business expenses. As a result, careful consideration should be made to determine if part or all of particular SALT expenses or miscellaneous expenses could properly be allocated to an on-going business. Of course, any such allocation should be done with care since doing this improperly could be considered tax fraud or tax evasion. At least one commentator has stated that using a business check to improperly pay such an individual expense could itself be tax fraud or evasion. However, this should not be the case as long as the payment is treated properly on the books and records of the business and on applicable tax returns.
As for employee business expenses, the employer can resolve this issue by changing to an accountable reimbursement plan where the employer reimburses the employee for business expenses after the employee provides the employer with evidence of the expense. In this case, the employer takes the normal business deduction and the employee does not receive any reportable income for these reimbursements.
C. Child and Other Qualified Dependent Tax Credits
While these type credits are normally limited to those with lower incomes, the 2017 Tax Act increases the ability for many more to benefit from the child tax credit and creates a new qualifying dependent tax credit. The child tax credit is $2,000 per child below the age of 17 during the year (of which up to $1,400 is refundable), and it does not begin to phase out until income exceeds $400,000 (MFJ) or $200,000 (all other taxpayers). A new qualified dependent tax credit of $500 (none of which is refundable) is now also available for supporting a person who is not a qualified child. It should be noted that the new $500 qualified dependent tax credit likely applies to dependent children over the age of 16. The same child tax credit phase outs apply to the qualified dependent tax credit.
D. Kiddie Tax
A child’s earned income is taxed at the child’s tax rates. However, a child’s unearned income is taxed differently to the extent it exceeds $2,100 (first $1,050 is tax free and next $1,050 is taxed at the child’s tax rate). A child for this purpose is single and can be as old as 23 if a full-time student. Prior to the 2017 Tax Act, such excess unearned income was taxed at the parents’ tax rate. However, under the 2017 Tax Act, the result is likely way worse, albeit somewhat simpler. Instead of taxing this excess unearned income at the parents’ tax rate, it will be taxed as if earned by a trust. Under current law, trusts use the individual tax rates but the tax brackets are significantly compressed, so trust’s get to the highest federal individual tax rate of 37% at $12,500, instead of at $500,000 (single) or $600,000 (married filing jointly). The good news is that no change was made the Net Investment Income Tax (NIIT) of 3.8% on passive investment income, so it does not begin to apply until the child has taxable income of $200,000. The bottom line is that care should be taken to avoid the kiddie tax for all except parents who are themselves in highest tax bracket.
E. Taxation of Alimony
Beginning with divorce or separation agreements executed after December 31, 2018, the taxation of alimony in divorces changes radically. Historically, the ex-spouse paying alimony would deduct it and the ex-spouse receiving alimony would pay tax on it. Normally, this meant that the lower income spouse would end up paying tax on the alimony at their lower tax rates. This difference in who pays tax and at what rate also helped in settling disputed divorce cases. However, the 2017 Tax Act changed this taxation so alimony was neither deductible by the payor nor taxable to the receiver. While this may not have a significant effect on government revenues, it will likely make settling divorces more difficult, and it may result in lower income ex-spouses receiving less alimony (support).
F. Obamacare Taxes
The additional Obamacare (Affordable Care Act) taxes of 0.9% on compensation and 3.8% on net investment income (NIIT) remain unchanged. These taxes apply to those making more than $200,000 (single) or $250,000 (MFJ).
The Obamacare penalty for failing to have proper health insurance (more technically known as the shared responsibility payment for failing to maintain minimum health coverage) is eliminated beginning in 2019. It was the elimination of this penalty that helped pay for the 2017 Tax Act. By removing this requirement, the government would save money by not having to directly subsidize health insurance premiums for as many people. Of course, these savings may only be illusory since those without health insurance may still end up needing actual medical care that they cannot afford, and may thereby get it for free, indirectly causing added costs for hospitals, health insurance companies, states, and the federal government, which will in turn increase costs for taxpayers who have adequate health insurance.
G. 529 Plan accounts
529 Plan accounts can now be used up to $10,000 per year for private school tuition for K-12 education.
In addition, up to $15,000 per year may be rolled over from a 529 Plan account to an ABLE Act account for a disabled individual. While disability based payments may be made from 529 Plan accounts directly without the otherwise applicable 10% penalty on the income portion of a non-qualified educational expense based payment, the income portion is still subject to income tax. However, ABLE Act accounts used to provide disability based benefits are received income tax and penalty free.
H. Other Misc. Personal Income Tax Changes
(1) Reversing Conversion of Regular IRA to Roth IRA.
After a regular IRA was converted into a Roth IRA, prior law permitted the conversion to be reversed if it was done by the due date for filing the income tax return for that same tax year, which could be as late as October 15th of the following tax year. This reversal option permitted a Roth that decreased in value before the tax return was filed to be recharacterized back to a regular IRA. Congress decided that this flexibility was not intended and has now prohibited a Roth IRA conversion from being recharacterized back to a regular IRA.
These permanent changes in the law require certain filings when a life insurance policy is transferred. A lot of life settlements and life insurance policy sales take place in the dark between unrelated parties, and the IRS wants to have notice of what is happening in case taxable income or gain is being incurred. It also reverses an aggressive IRS Rev Rul. 2009-13 which provided that the taxpayer’s basis in a life insurance policy needed to be reduced by the cost of insurance. The 2017 Tax Act provides that the basis of a life insurance policy for determining recognitions of gain or loss should not be decreased by the cost of insurance charges.
3. Business Income Taxes
A. C Corporation Tax Rates
C corporation tax rates are a flat 21% and the corporate AMT has been repealed.
B. 20% Deduction on the Taxation of Qualified Business Income from Pass-Through Entities (IRC Section 199A)
This is by far the most complex aspect of the 2017 Tax Act. The idea was to provide some benefit to small businesses, which are normally organized as sole proprietorships and pass-through entities. Larger businesses are often organized as C corporations, which got the bulk of the benefits under the 2017 Tax Act.
In general, qualified business income from pass-through entities (QBI) is provided with up to a 20% deduction to lower the effective tax rate on this type income. The bad news is that this deduction is subject to significant limitations and is seriously complex.
It should be noted that QBI is to represent active business’s net income and, in general, does not include passive investment income or the owner’s wages / reasonable compensation.
In addition, while business income of professional service companies is not generally given this benefit, an exception was made to permit owners of professional service companies with lower taxable incomes to benefit, defined as those with taxable income below $157,500 (single) or $315,000 (MFJ). A partial benefit / phase out does exist for owners of professional service companies with taxable incomes between $157,500 – $207,500 (single) or $315,000 – $415,000 (MFJ). Specified service companies include those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees, but specifically not including engineering and architecture.
In dealing with this potential 20% deduction, think about the rules being in 3 buckets.
First bucket: if the owner’s taxable income on their IRS Form 1040 (personal income tax return) does not exceed $157,500 (single) or $315,000 (MFJ), then the full 20% deduction is applicable for all QBI, including from specified service companies.
Second bucket: if the owner’s taxable income on their IRS Form 1040 is between $157,500 – $207,500 (single) or $315,000 – $415,000 (MFJ), then the QBI, including specified service companies, can qualify for the 20% deduction, but it is subject to phase out and various limitations. These phase out and limitation rules are the most complex rules in the 2017 Tax Act.
Third bucket: If the owner’s taxable income on their IRS Form 1040 is over $207,500 (single) or $415,000 (MFJ), then all income from specified service companies is disqualified. Other QBI qualifies for the 20% deduction, but it is capped at the greater of: (a) 50% of W-2 wages, or (b) the sum of 25% of W-2 wages plus 2.5% of the unadjusted acquisition basis of the business’s depreciable tangible property.
C. Planning Considerations
The business planning under the 2017 Tax Act is significant. Should the business be left as is, modified into a different type entity, or separated into multiple entities with each providing some service or product to the others? These issues are important since income from specified service businesses does not qualify for the 20% QBI deduction if the owner’s taxable income is too high, as discussed above. So, what income really needs to be earned in a specified service business vs having other businesses provide ancillary services to the specified service business? Alternatively, income that could be saved rather than currently spent could be sheltered in a C corporation, with the concern of the eventual tax cost to distribute the accumulated income in the future. In addition, steps could be taken to keep the owner’s taxable income on their IRS Form 1040 within the first bucket discussed above if a specified service business is involved. Lastly, for non-specified service businesses, need to ensure the wage or wage/basis tests do not limit the 20% QBI deduction.
D. Other Misc. Changes
(1) Depreciation. Expensing and depreciation of business assets will be improved with full expensing from Sept. 2017 until Dec. 31, 2023, and with this being phased out 20% per year thereafter from 2023 until 2026. In addition, the Section 179 expensing deduction is increased from $500,000 to $1 million.
(2) Fringe Benefits. Fringe benefits, including some significant business entertainment expenses, are being limited. In particular, expenses are no longer deductible that are related to entertainment, amusement, or recreation activities or for the membership dues to any club organized for business, pleasure, recreation, or other social purposes. However, the 50% deduction for business related meals remains unchanged.
(3) Interest deductibility. Interest deductibility is somewhat limited for businesses with average annual gross receipts of at least $25 million.
(4) Like-king exchanges. Like kind exchanges to defer the gain on the exchange of like-kind assets is now limited to real property exchanges.
(5) Net Operating Losses (NOLs). The use of NOLs is now somewhat more limited.
(6) Carried Interest. Carried interest is the name for the ability for some to obtain preferential long-term capital gain treatment on what is effectively compensation income where their compensation is received in the form of a profits interest in a partnership taxed entity. This was the low hanging fruit to help pay for the Tax Act by getting rid of this unfair tax loophole. Well, it did not happen. The only change made was to provide that long-term capital gain treatment could not be achieved until the interest was held at least three (3) years rather than the normal one (1) year. Bottom line is that this change will have minimal, if any, effect on this tax loophole.
4. Wealth Transfer Taxes (Gift, Estate and GST Taxes)
A. 2017 Tax Act Changes
As discussed above, the Basic Exclusion amount (the combined gift and estate tax exemption) and the GST tax exemption are both doubled from $5 million each to $10 million each, indexed for inflation. Also, as discussed above, portability continues to apply to the Basic Exclusion amount but not to the GST tax exemption.
B. The Practical Effect of the 2017 Tax Act Changes
For the mass majority of taxpayers, the wealth transfer taxes are no longer a negative. At worst, they require some potential tax filing requirements, but no tax liabilities will likely ever be due. However, the step-up in income tax basis (actually a change in tax basis to date of death value) is an income tax benefit achieved at death by most taxpayers. At the current, but temporary, exemption amounts of $10 million plus indexing for inflation (projected to be approximately $11.18 million in 2018), it is likely that well less than 1% of society will be at a significant risk of ever paying any wealth transfer taxes. If the exemptions return to pre-2017 Tax Act amounts, it is likely that less than 2% of society will ever be at a significant risk of ever paying any wealth transfer taxes. By doubling the exemptions, the wealth transfer taxes will be left to serving their only legitimate public purposes, i.e., the prevention of dynasties over generations of accumulated wealth and the encouragement of using one’s wealth to benefit the public in general, through significant charitable giving.
C. Planning Considerations
1. Changes are temporary Because this doubling of the exemption sunsets after 2025, taxpayers who needed to do estate tax planning with the exemptions before the 2017 Tax Act still need to seriously consider such planning. Further, the ultra-high net worth who will still need planning even if the doubling of the exemptions is made permanent, should undertake serious planning before the end of 2025 in order to lock in these exemption increases.
2. Non-tax benefits of estate planning still drive the plan. As is normally the case, estate planning will primarily concentrate on the non-tax benefits of planning (carrying out wishes with least cost and hassles, choosing who will carry out your wishes, and maximizing control and asset protection) while taking advantage of tax benefits available under current law. From this perspective, the tax issues are one of a structuring overlay rather than being the driver of the overall plan.
3. Flexibility remains critical with proper planning. Flexibility is still needed to deal with changed circumstances as to particular beneficiaries, family dynamics, federal and state tax laws, and other non-tax related state laws. Today the exemptions have been doubled, but who knows what tomorrow will bring? State laws are being liberalized and are becoming more flexible. As the wealth transfer taxes are becoming less important, income taxes are becoming more important. Asset protection (the protection of assets from unwanted outsiders) remains a key benefit that can be achieved for family members with proper planning.
4. Lots of planning options to consider in today’s changing environment. Some planning is the same that we have done for many years, while other planning options stem from the opportunities arising from the increase in wealth transfer tax exemptions and increased importance of asset protection and income taxes. Whatever planning options are best is always dependent on the particular client’s situation and objectives.
5. It is time to review your estate plan with your attorney. While you may or may not need to make any significant changes to your estate plan because of the changes under the 2017 Tax Act, this is still a great time to determine if any such changes are needed and to do your normal plan maintenance by updating your Powers of Attorney and Advance Directives for Health Care.
1The first complexity to come from this tax act is its name. While we will refer to it as the “2017 Tax Act,” and it has a common name of the “Tax Cuts and Jobs Act,” its legal name is much more complex. Specifically, the name of this tax act is, “To provide for reconciliation pursuant to titles II and V of the concurrent resolution of the budget for fiscal year 2018.”