Year-end tax planning was a fraught exercise in 2017 as tax reform made its way through Congress. Now that the legislation is the law of the land, the dust has begun to clear.
Most people whose tax situations are not unusually complex have already filed their 2017 tax returns, which were not impacted significantly by the new law, but tax planning should be an ongoing process. Understanding changes taking effect this year, and a few that are scheduled for later, will allow taxpayers to make wise choices going forward.
As expected, the biggest change for most individuals in the short term will likely be the new set of individual income tax brackets. The final version of the tax plan preserved the seven existing brackets, but reduced the rate for most of them and significantly raised many of the thresholds at which taxpayers move up to the bracket above. The top marginal rate dropped from 39.6 percent to 37 percent. Many wage earners have already noticed an increase in their take-home pay due to lower tax withholding. These cuts are set to expire in 2025 unless Congress extends them. Lawmakers ultimately did not jettison the individual alternative minimum tax entirely, but did raise the income threshold so that it will affect fewer taxpayers.
Also unsurprisingly, the final law incorporated the plan for an increased standard deduction that appeared in both the original House and Senate bills. Starting this year, single taxpayers’ standard deduction will nearly double from $6,350 to $12,000; married couples filing jointly will have a deduction of $24,000, up from $12,700. The Child Tax Credit doubled, as per the Senate bill, from $1,000 to $2,000 per qualifying child. The law also added a $500 credit for dependents who are not children. These changes are likely meant to make up for the fact that personal exemptions, including those for dependents, have been eliminated.
For many taxpayers, the change to the standard deduction will represent a major adjustment to the way they approach their income taxes, making the threshold for usefully itemizing deductions much higher. Those who do still itemize, however, will find that many of the deductions they are accustomed to taking have vanished or diminished. The amount of deductible state and local property, income and sales taxes will now be collectively capped at $10,000. The size of loans eligible for the mortgage interest deduction has been reduced from $1 million to $750,000 for new loans, although loans closed before Dec. 15, 2017 will be grandfathered into the old limit. Interest on home equity debt can no longer be deducted at all.
The charitable deduction and the medical expense deduction remain intact. The former comes with an increase on cash contribution limits, and the latter is temporarily expanded to cover expenses that exceed 7.5 percent of adjusted gross income for tax years 2017 and 2018. The threshold will return to 10 percent in 2019. The final law also preserved the popular “above-the-line” deduction for student loan interest and the deduction for tuition waivers for graduate students. Lawmakers have eliminated many other itemized deductions, though fewer than some originally anticipated. For many taxpayers, this change will be moot, since the Joint Committee on Taxation estimates that 94 percent of U.S. households will claim the now-raised standard deduction. But either way, it will represent a substantial change in how many Americans approach their income taxes.
Going into the tax reform process, the estate tax was a particular target for lawmakers. While the new law kept estate taxes in place, the lifetime exemption threshold for estate and gift taxes increased from $5.6 million to $11.2 million for individuals, an amount indexed to inflation until 2025. Relatively few taxpayers had to worry about the federal estate tax before this change; now that number is even smaller, with obvious implications for a variety of estate planning techniques designed to provide tax shelter.
The expected change to Section 529 savings accounts also made it into the final version of the bill. These plans were previously earmarked for the cost of higher education only, but parents can now use 529 funds for tuition at private K-12 schools as well. This change represents a major shift in planning for educational expenses, because while it expands the options for qualified expenses, it also potentially shortens the timeline over which assets can grow tax-free.
The Tax Landscape For Small Business Owners
One of the biggest areas of uncertainty in the new law’s application is how it will affect pass-through business entities such as limited liability companies and partnerships. While not all pass-through entities are small businesses, many small businesses are structured this way.
Under the previous tax regime, pass-through income was taxed at the owner’s ordinary income tax rate. The new law, however, introduced a 20 percent deduction on qualified pass-through business income, subject to certain limits. That sounds simple, but in practice there are a lot of variables at play, and some are still unknowns.
Taxpayers with total income below $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly are eligible for the 20 percent deduction against their pass-through business income. Above those thresholds, various limitations can come into play.
First, there is the designation of a specified service trade or business, a subset of pass-through entities with special rules. Service businesses include those in the fields of health, law, consulting, financial services and a variety of others. In most cases, if what you are selling is your own skill or expertise, your organization may be a service business. This distinction comes from existing tax code, not the new law itself, and some have argued that it leaves a large gray area undefined. Owners of service businesses whose incomes are above the thresholds are subject to a phase-out of the deduction between $157,500 and $207,500 for single taxpayers, and $315,000 and $415,000 for married taxpayers.
Service businesses within the phase-out range and taxpayers who receive pass-through income above the thresholds from nonservice businesses are both limited to deducting no more than 50 percent of the taxpayer’s pro rata share of the total W-2 wages that the business paid, or 25 percent of wages paid plus 2.5 percent of total depreciable assets of the business, whichever is greater. This provision, like the distinction between service and nonservice companies, is meant to deter abuse of the new deduction. And for both service and nonservice businesses, a taxpayer’s deduction cannot exceed his or her taxable income for the year reduced by net long-term capital gains and qualified dividends.
Believe it or not, what I have sketched out above is a simplified version of the deduction. The details can get substantially more complicated. Further, the distinction between service and nonservice businesses may warrant some additional tax planning in certain situations because of its inherent ambiguity. For example, if your business has both service-based and nonservice-based components, it may make sense to restructure the business and segregate the different business lines in order to partially avoid the more strict requirements placed upon the service-based portion of your business.
Corporate taxation was arguably the biggest focus of the tax plan, as reflected in the fact that the law permanently reduced the top corporate tax rate from 35 percent to 21 percent and eliminated the corporate AMT entirely. Multinational corporations will also benefit from the shift from a worldwide tax regime to a territorial system, where U.S. companies will pay tax only on profits earned in the U.S., and from a repatriation tax designed to encourage companies to bring cash reserves held elsewhere back to the United States. For businesses organized as corporations, these changes represent a straightforward win. Congress clearly intended the change to pass-through income to close the gap between corporate taxation and pass-through taxation.
However, because of how pass-through entities work, the new system will inevitably complicate matters for these businesses, especially in the first few years. That complication could very well yield a benefit in the form of fewer dollars sent to the Internal Revenue Service, but tax preparers and business owners alike are still working out how best to comply with the new law absent further guidance from Congress or the IRS. It is also worth noting that, unlike the corporate tax rate cut, the pass-through deduction will expire in 2025 if it is not extended.
There are also a variety of other changes business owners should note, which are beyond the scope of this article. These include changes to expensing rules in the short term and changes to net operating loss rules. Many, if not most, small business owners will benefit from sitting down with their tax professional to discuss the full effects of the new law.
With so many provisions of the new tax law set to expire in the next five to seven years, and considering that we will almost certainly see more guidance from the IRS in the meantime, it is important that taxpayers remain flexible as they update their long-term tax plans. For business owners, this is doubly true. But uncertainty is part of life, and paralysis is never the best option. Press on, ask for help if you need it and take full advantage of any new benefits the tax law brings to you.