Tax Reform Proposals Revisited (Yet Again!)

Take-Away: I know you spent most of the weekend reviewing the proposed tax law that the Committee released late last week. (Hopefully you have more of a life than I do!) So what follows is pretty much repeat of what you already know with a few thoughts of my own.

Standard Deduction: This goes from $6,350 to $12,000 for a single person, and from $12,700 to $24,000 for a married couple. Best to pay pledges and make charitable contributions before the end of 2017 since most taxpayers will no longer avail themselves of itemized deductions and will instead fall under the standard deduction. Seems to me that charities will be hit the hardest with this proposed legislation.

Personal Exemptions: The current $4,050 per taxpayer and dependent will disappear. This loss of exemptions will hurt the lower and middle-class taxpayer. Supposedly it is offset by the higher standard deduction; I am not sure I agree with that ‘spin.’

State and Local Tax Deduction: After much controversy and debate, this deduction stays in the tax code, but it is capped at $10,000 per tax itemizer. It covers local and state income, sales and property taxes paid.

Charitable Deduction: This deduction stays in the tax code, but due to the ‘doubling’ of the standard deduction, it probably will not be much of a benefit for most taxpayers. Hence the suggestion to pay-off charitable pledges, if possible, in 2017 so that some income tax benefit will be derived from that charitable giving.

Mortgage Interest Deduction: This deduction stays in the tax code, but it is limited to interest paid on mortgage loans up to $750,000 (down from the current $1.0 million mortgage balance.) Existing mortgage loans are ‘grandfathered’ from this rule change. This deduction covers interest paid on mortgages incurred for first and second homes. However, there will be no deduction for interest paid on home equity lines of credit; currently the interest paid on a $100,000 home equity line of credit is deductible.

Medical Expense Deduction: This deduction remains for the next two years- 2018 and 2019. It is actually increased from the current excess of medical expenses incurred above 10% of reported adjusted gross income. For the next two years, the threshold adjust gross income amount will be 7.5% not 10%.

Misc. Deductions: The deduction for student loans remains, as does the deduction for teacher-paid classroom supplies. Also preserved is the tax-free status of tuition waivers for graduate students.

Child Care Credit: The credit is increased from $1,000 to $2,000 for children under the age of 17 years. This increase will help high earners more than low and middle income parents whose net taxable income nets out at zero. The income threshold is increased for single taxpayers to $200,000 (up from $75,000) and $400,000 for a married couple (up from $110,000.) The first $1,000 of the credit is refundable; $400 of the second $1,000 credit is refundable.

Dependent Credit: There is a new $500 ‘temporary’ credit for non-child dependents, e.g. elderly parents, adult children with disabilities, and children who are 17 years of age and older, who are supported by the taxpayer.

Alternative Minimum Tax: The AMT was repealed for businesses but retained for individuals. However, the income exemption for individuals was increased: for single taxpayers the exemption amount is $70,300 (that is up from $54,300) and for a married couple, the exempt earned amount is now $109,400 (up from $84,500.)

FIFO: This potential rule change did NOT make its way into the compromise tax bill. This rule would have prevented taxpayers from choosing among lots of stock which to sell first, or which to gift, so as to minimize gains on sales or ‘cherry pick’ higher basis stock to gift during lifetime. That flexibility to pick-and-choose which lot of stock to sell or gift remains.

Affordable Care Act Mandate:  The Joint  Committee Bill eliminates the mandate to purchase health insurance. There will be no penalty imposed if the decision is made to not purchase health insurance. This reduces amounts that the federal government spends on insurance subsidies and Medicaid. As a result you can expect health insurance premiums to increase in 2018 as healthy people might skip paying for health insurance, thus increasing the risk pool of insureds.

Business Taxes: The corporate tax rate is cut from 35% to 21% starting in 2018.

Pass Through Entities: Expect this to get the most attention starting in 2018. Owners, partners, shareholders of Subchapter S corporations and LLCs [referred to as pass-through entities] will all have their taxable income lowered by a 20% deduction [the Senate Bill had proposed 23%.] [New Code Section 199A] However, this deduction will be denied to those who taxpayers who are in service industries, e.g. lawyers, accountants, physicians, unless their taxable income is less than a targeted dollar amount: $157,500 for single earners, and $315,000 for married earners. Why can we expect ‘games’ beginning in 2018? Well, if the earner takes a salary from his or her business, they will be subject to ordinary income tax rates. If, instead, the earner converts their salary to a profit distribution they will be eligible to claim the 20% deduction. This 20% deduction seems to favor ‘passive’ owners of pass through businesses over ‘active’ owners who run the business. This deduction will also be available to trusts and estates that hold pass through entities. That being the case, if a trust or estate is using something other than a calendar year end fiscal year, it might make sense to convert to a calendar year-end so that beginning on 1/1/18 the income the trust or estate receives from the entity so held will be subject to the 20% deduction.

Estate Taxes: The federal estate tax was not repealed. However, the estate and GST exemption amount was doubled for each taxpayer, going from $5.49 million to $10.98 million. But since it was not repealed, the estate tax (and GST tax) comes back with a full force on January 1, 2026. At that time there will be an exemption amount per taxpayer which is subject to a limited cost-of-living escalator from 2018 to 2026. The projected exemption per taxpayer beginning in 2026 is somewhere between $6.0 and $6.5 million. Since the larger exemptions disappear after 2025 there is still a premium on estate planning for those wealthy enough to worry about federal estate taxes. This may be the occasion where a wealthy client might want to consider using some of the wealth to fund a dynasty-type trust, a transfer that will avoid incurring any federal gift tax due to the now ‘doubled’ federal gift tax exemption amount, and also the ‘doubled’ federal GST exemption amount. If wealthy clients are unwilling to part with another $5.5 million (or $11 million if married) they might consider funding Spousal Lifetime Access Trusts (SLATs) to use the enlarged exemptions while they exist, while still having access to the income generated by the transferred assets held in the SLATs.

Income Taxes: We will still have 7 income tax brackets ranging from 10% up to $9,525 for a single individual and  $19,050 for a married couple ) to 37% (on income over $500,000 for individuals and $600,000 for a married couple). But all of those individual brackets and rates will expire at the end of 2025.