Tax Reform: So How Do We Advise Our Clients?

Take-Away: Ignoring for the moment the media’s rhetoric if the pending tax reform law is good policy or bad, a Christmas gift to the middle class to the 0.01% of the populace, or if the end result is a large step towards national insolvency, it is the law and we are obliged to advise our clients on how they might respond to those changes in their personal tax planning. What follows is a terse summary of some of the tax law changes and how some of our clients might want to consider taking advantage of those changes. Caveats: #1 Every client’s income and investment situation is different so they will ultimately need to consult with their tax and legal advisors before pursuing any possible strategy. #2 The list of periodic planning suggestions is by no means exhaustive.

Under-the-Radar Business and Individual Changes: These changes have not gotten much attention in the media, but they are also part of the tax law changes:

Full Asset and Equipment Expensing: The expensing of investments in new depreciable assets before 1/1/2023 is 100%. After that date the full cost expensing is phased out at the rate of 20% a year between 2023 and 2027.
IRC 179 Deduction: The depreciation deduction limitation has increased to $1.0 million a year.
Curtailed Business Deductions: Deductions for some fringe benefits, like business entertainment expenses, will now be limited.
Net Operating Losses: NOL deductions will be limited to 80% pre-NOL taxable income. The losses can still be carried forward indefinitely, but there will be no ‘carrybacks’ of NOLs for prior tax years.
Tax Preparation Fees: These fees are no longer deductible, but only through 2025.
Moving Expenses: The expenses are no longer deductible, but only through 2025; one exception to this tax law change is for members of the armed forces who can still deduct moving expenses.
Roth ‘Re-characterizations’: The ability to re-characterize a conversion of a regular IRA to a Roth IRA is eliminated, beginning after December 31, 2017. Not much time remains if a client wants or needs to ‘re-characterize’ their Roth IRA.
Expansion of 529 Account Expenditures: A 529 account will now be able to be used for K through12 school expenses and for homeschooling expenses. [This should make Betsy DeVos happy.]
Alimony Not Deductible: The deduction for alimony paid by an ex-spouse, and the inclusion of that alimony as taxable income to the recipient, is eliminated for a divorce or legal separation instrument that are executed after December 31, 2018, and applies to some modifications to those instruments before that date. [Hopefully someone will inform divorce judges of this major shift in the income tax burden of spousal support obligations, since most divorce judges choose to be blissfully ignorant with regard to the income tax consequences of the divorce judgments that they impose.]
Life Insurance Dividends: New reporting, reserves, and capitalization rules will be imposed on life insurance companies. The upshot of these changes is a probable reduction in the amount of dividends that the insurance companies will be able to declare issued on their whole life policies.
Viatical Contracts: An exception to the tax code’s ‘transfer for value’ rules for the purchase of life insurance policies was significantly narrowed; now, at least a portion of the death benefit will be taxable to the purchaser of the life insurance contact. New IRS reporting will also be required by the purchaser, not just imposed on the life insurance company, so that the ‘basis’ i.e. the purchase price, can be documented by the IRS.
Cash Charitable Contributions: The charitable contribution limit for cash gifts to charities is increased from 50% to 60% of adjusted gross income. Contributions of appreciated assets will still be limited to 30% of the donor’s adjusted gross income. [I am not sure that increasing the adjusted gross income limit for cash gifts to charities will off-set the probable drop in charitable giving with the ‘doubling’ of the standard deduction.]

Transfer Taxes: Despite all the hyperbole about ‘killing the death tax’ it is still with us. The estate, gift and GST exemption amounts are doubled however, from $5.0 million to $10.0 million per taxpayer. But this ‘doubling’ of the exemptions disappears at the end of 2025. Thus, there exists an 8 year opportunity to unload a lot of wealth through lifetime gifts. The transfer tax exemption amount will continue to be adjusted annually for cost-of-living, but there is some of ‘slight-of-hand’ at work. In the past the exemption amounts were directly tied to the CPI. Going forward the adjustments to the exemption amounts will be tied to what is informally called the chained CPI. The chained CPI accounts for consumer preferences to substitute cheaper goods during periods of high inflation. The upshot of using the chained CPI as the adjustment mechanism is that the cost-of-living adjustments to the exemption amounts over the next 8 years will not be nearly as robust as in the past, e.g. the increase from 2017 to 2018 alone was scheduled to be $110,000. Some of the planning considerations associated with the effective increase in each individual’s exemption, going from $5.0 million to $10.0 million include-

Use It or Lose It: Since there is a defined ‘shelf life’ for the ‘doubled’ exemption amount, it would be a good idea to use the exemptions while it exists, or a future Congress changes its mind. That means for really wealthy couples they should consider funding ‘dynasty’ type trusts for their children and grandchildren using both their ‘new’ gift tax exemption amount ($5.0 million each) and the ‘new’ GST tax exemption amount ($5.0 million each) so no transfer taxes are paid. These lifetime gifts will move those assets and any future appreciation of those gifted assets (permanently) away from federal estate taxes for the owner as well as their children and grandchildren, while providing some level of creditor protection to those transferred assets for the owner’ children and grandchildren.
Spousal Lifetime Access Trusts: For wealthy married couples who are reluctant to permanently gift their assets in anticipation of their own future cash-flow needs, spousal lifetime access trusts (SLATs) should be considered, just like back in 2012 when they were the rage of estate planners. The assets (and their future appreciation) are removed from the couples’ taxable estates, while the couple will continue to receive the income from the transferred assets held in each SLAT; each is the designated income beneficiary of the irrevocable SLAT created for them by their spouse. Their ‘new’ $5.0 gift tax exemption is used to cover the lifetime gift to the SLAT. Again, creditors of the spouse are also thwarted by the spendthrift provision included in the typical SLAT. The SLAT can also be set up as a dynasty trust to hold the transferred assets for children and grandchildren after the spouse’s death; the assets will also be sheltered from the GST tax since that $5.0 million exemption is also used when the SLAT is initially funded by the grantor. In sum, with the SLATs, the new increased exemptions are currently used but the couple who create and fund the SLATs for each other continue to have access to the SLAT’s income from the transferred assets for their lifetimes.
Grantor Retained Annuity Trusts: Consider the creation of an 8 year grantor retained annuity trust (GRAT.) If the grantor dies during the next 8 years, the GRAT assets will be included in the grantor’s taxable estate, and thus their estate will benefit from an income tax basis adjustment, but that estate inclusion may still not cause a federal estate tax if the decedent’s estate tax exemption remains somewhere above $10 million. (Yes, the ‘step-up’ in basis rules on the owner’s death remain a part of the tax code.) If the grantor survives the 8 year GRAT term, to the extent that the GRAT assets appreciated over the 8 years at a faster rate than the IRS interest rate that was required to be used when the GRAT was initially funded (called the hurdle rate– the GRAT only ‘works’ when the internal rate of return on the GRAT’s investment assets exceed the AFR rate used when setting up the GRAT up) all that ‘excess’ growth passes to the grantor’s children, grandchildren, or to a dynasty trust established for their benefit, free from any gift tax.
Don’t Abandon ILITs: As noted, the federal estate and GST taxes were not repealed so there is a pretty good chance that they will return in some form either in 2026, or perhaps as early as 2021 if there is a new sitting President. [The word permanent is seldom used in connection with Congress, other than a member’s innate ability to continue to be re-elected when he or she essentially does very little other than posture in public, point fingers across the aisle, and from time to time offer pithy soundbites for CNBC or Fox News. Sorry, don’t get me started.] There may still be a strong reason to retain life insurance, or insurance policies held in ILITs to meet that future potential liquidity need when the exemption falls back to today’s amount, or Congress decides that this new tax law is not working the way that it promised us it would work to generate lots of future tax revenues.
State Taxes: While the federal government may have temporarily ‘left the estate tax playing field’ don’t forget the states, and their continuing need for revenues. Clients might be distracted by the ‘doubled’ federal estate and GST tax exemption amounts, but states may very well continue to impose their transfer taxes, or they might even be encouraged to fill the tax-void left by the federal government. Now would be a good time to assess what exposure clients have to state estate and inheritance taxes and possibly take steps to avoid their imposition on assets located in those states where imposing a state estate tax is ‘fair game.’
Lifetime Gifts to Shift Income: Each taxpayer now has a $10 million gift tax exemption. Arguably a taxpayer in the highest marginal income tax bracket [37%] could gift $1.0 million to a child who is in the 10% income tax bracket. Indirectly transferring the income generated off of the gifted $1.0 million could lower the donor’s tax bracket, or eliminate the donor’s exposure to the 3.8% Medicare surtax. If the donor ever needed to improve their cash-flow in future years, the donee could gift back the same $1.0 million to their donor, since the donee also has a $10.0 million gift tax exemption. We were told that the gift tax is in place to prevent income-shifting between taxpayers or between generations who are at different income tax brackets. [Well, so much for that reason for imposing a gift tax, to ‘prevent income shifting games.’]

Personal Income Tax Rates and Brackets and Deductions: We still will have seven income tax brackets but with lower rates ranging from 10% to 37%, effective 1/1/2018. Obvious strategies to consider in light of these changes with an eye toward the ‘doubling’ of the standard deduction and the elimination of, or ‘dollar capping,’ some long-standing income tax deductions include:

Defer income and Accelerate Deductions: What is best depends on what calendar year will provide the most tax saving to the client. Number crunching is needed to make this decision to accelerate or to defer income or deductions.
Sales of Businesses and Appreciated Assets: If these sales are more than likely to occur in 2018, considering reporting the sale as an installment sale.
Exchanges: In order to avoid the present recognition of gain on the sale of some real estate, consider a like-kind exchange under IRC 1031 to defer recognition of that gain.
Harvest Losses: If an asset will be sold at a loss, consider harvesting that loss in 2017 (if there is still time) where it will be more impactful when income tax rates are higher. Beware of the ‘wash sales’ rule when substantially similar securities are purchased in the following 30 days, which prevents declaring the loss.
Personal Exemptions: The $4,050 personal exemption is repealed. This elimination will push more taxpayers into claiming the now ‘doubled’ standard deduction, which means that future deductible expenses they incur may never actually reduce their future income tax bills.
State and Local Taxes: For itemizers, this deduction will be capped at $10,000 a year, beginning in 2018. Again, the $10,000 ‘cap’ will push more taxpayers to file a Form 1040 EZ return. Some taxes might be accelerated to this year, but even if accelerated they will probably have no real impact on this year’s AMT.
Medical Expenses: The 10% of adjusted gross income ‘floor’ for this deduction was reduced to 7.5% for only 2017 and 2018. Clients should consider accelerating (prepaying) medical expenses into those two calendar years to exploit this tax deduction while it exists.
Mortgage Interest: There is still a deduction for mortgage loans with a loan balance of no more than $750,000. Existing mortgage loans with balances of less than $1.0 million are ‘grandfather’ and do not have to comply with the dollar limitation.
Home Equity Lines of Credit: Interest will no longer be deductible on a home equity line of credit after 2017. Consider either paying off the line of credit or converting it into a home mortgage loan with a balance of less than $750,000.
Charitable Contributions: While still deductible these contributions may not help to reduce income tax liability due to a taxpayer’s ‘doubled’ standard deduction. Consider aggressively funding a donor advised fund before the end of 2017 to gain the tax benefit for any future planned philanthropy, or prepay outstanding charitable pledges this year when the tax deduction may still work to reduce a taxpayer’s 2017 income tax liability.
Medicare Surtaxes: The 0.9% tax on earned income and the 3.8% net investment income tax [the Medicare surtax] remain. These taxes will apply to single taxpayers ( with $200,000+ income) and married joint filers (with $250,000+ income.) Thus, don’t get distracted by the lower marginal income tax rates without also factoring in these ‘add-on’ taxes.
Alternative Minimum Tax: The exemptions from the AMT were increased along with the phase-out of the increased exemption ($500,000+ single filers, $1.0+ million married joint filers.) Clients who have incentive stock options (ISOs) may want to exercise them when they are not subject to the AMT due to the higher exemptions before the AMT ‘phase-outs’ apply [when the ISO is exercised, the difference between the stock’s FMV and the option price is included in the taxpayer’s AMT base.]

Corporate Income Taxes: The two biggest changes to corporate taxation are the new permanent corporate income tax rate of 21% starting in 2018, and the repeal of the corporate AMT.

Buy-Sell Agreement Life Insurance: This lower tax rate and the elimination of the corporation’s AMT might prompt a second-look at life insurance owned by the corporation on its key employees. Any death benefit received by the corporation used to be subject to the AMT, which will no longer be the case since there will be no corporate AMT exposure. These changes might prompt more corporations to enter into a corporate owned life insurance ‘buy-sell’ agreement that insures the lives of its shareholders: (i) lower income tax rates will be imposed on the corporation paying the policy premiums; and (ii) no AMT tax will be imposed on the death benefit that the corporation receives on the death of one of its shareholders.

Pass-Through Business Entities: This is where the ‘big lie’ comes from Congress when it says that along with tax reform comes tax simplification. [That’s a crock if you are a small business owner!] For S corporations, partnerships, LLCs, and sole proprietorships a new deduction is created. {IRC 199A.} Describing that tax deduction is simple. The ability quantify and then to claim that deduction is anything but simple. [Caveat: what follows easily falls into the ‘blind leading the blind’ category. Try as I might to try to simplify these rules, clearly I have failed in that objective.]

New Deduction: There is a 20% deduction for the non-wage portion [call it the profit component] of the entity’s pass-through reported income. This ‘new’ deduction disappears beginning in 2026. Okay, that was the easy part.
Deduction Limit: The 20% deduction is limited, however, to: 50% of an entity’s W-2 wages for: (i) single-filers with income over $157,500; or (ii) married filers with income over $315,000. This limit is intended to prevent owners from converting their customary ‘wages’ [not entitled to the deduction] to ‘business’ profits [which can be reduced by the new business deduction.]
Phase-in: The range over which the W-2 limitation ‘test’ phases in is when the owner’s wage income exceeds the $157,500 or $315,000 threshold levels is: (i) $50,000 for a single taxpayer; and (ii) $100,000 for joint income tax returns.
Deductible Amount: Under IRC 199A, the deductible amount for a pass-through entity is described as the lesser of: (i) 20% of the taxpayer’s qualified business income with respect to the business; or (ii) the greater of (a) 50% of the W-2 wages with respect to the qualified business, or (b) the sum of 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property immediately after acquisition.
Let’s Try that Again: The 20% deduction is the smaller of either the taxpayer’s combined qualified business income or an amount equal to 20% of the excess of (i) the taxpayer’s taxable income for the taxable year, over (ii) the sum of the taxpayer’s net capital gain plus the aggregate amount of the quailed business dividends; plus (a) the lesser of (a) 20% of the aggregate amount of the taxpayer’s qualified dividends for the taxable year or (b) the taxpayer’s taxable income reduced by the net capital gain for the taxable year. About the only ‘take-away’ I can comfortably take from this delightful formula that limits the new 20% deduction for pass-through entities is that the deduction will never exceed the business’ taxable income reduced by the taxpayer’s net capital gain for the year.
Last-Minute Change: The byzantine 20% deduction ‘formula’ uses a reference to ‘wages.’ But what about a pass-through entity like an LLC that only holds commercial real estate? There are no wages associated with a real estate LLC or partnership. To clarify that the 20% deduction also applies to those types of entities there was a last minute change to the ‘formula’ to reference ‘capital assets.’ The ‘capital asset test’ added to the formula, which makes it even more convoluted, refers to a deduction of $25,000 or 2.5% of ‘capital assets’, whichever is lower (I think.) [I’m still moving my lips trying to read this last minute ‘clarification’ that is designed to benefit real estate holding entities.]
Key Definitions: The Joint Conference Committee imposes a limit for those taxpayers with taxable income above the two threshold amounts. It imposes a limit on either wages actually paid, or on wages paid plus a ‘capital element.’ Wages, as defined, includes amounts of elective deferrals for retirement plan contributions. The limit is the greater of either (i) 50% of the W-2 wages paid with respect to the business or (ii) the sum of 25% of the W-2 wages paid with regard to the business and 2.5% of the unadjusted basis (read: price paid) of qualified property acquired by the business, meaning tangible property that is subject to depreciation.
Apportionment: If there are more than two owners of the business each is treated as having W-2 wages and an unadjusted basis in qualified property in an amount equal to that person’s allocable share of all W-2 wages and the unadjusted basis of the qualified property for the year. If a trust or an estate owns the pass-through entity, the W-2 income is allocated between the beneficiaries and the fiduciary.
Professionals Excluded: As a gross generalization, higher earning professionals like those in health, law, engineering, architecture, accounting, actuary sciences, performing artists, consultants, and those in the financial services industry, i.e. stockbrokers, are prohibited from claiming the new 20% deduction. But then again, some ‘low earning’ professionals are permitted to claim the deduction, or a portion of the deduction. The impact of losing the deduction which is determined on a professional’s earned income can be dramatic. An example comparison follows:

An internist with no employees earns less than $315,000 a year; his reported income is $300,000. He also has net capital gain income of $25,000. The IRC 199A deduction is the lesser of 20% of his qualified business income ($60,000) or 20% of his taxable income in excess of his reported capital gains ($55,000). The internist’s deduction for the year under IRC 199A will be $55,000. Compare: An orthopedic surgeon earns over $415,000 a year. His professional service income is $400,000. He reports net capital gains of $25,000. His reported taxable income is $420,000 for the year. Under IRC 199A, no deduction is available for the surgeon’s business income when he files jointly and reports taxable income of $415,000 or more. Take-away: The internist who reported income of $300,000 of taxable income will be able to claim an IRC 199A tax deduction of $55,000, resulting in his reportable taxable income of $245,000. The orthopedic surgeon will report $420,000 taxable income with no IRC 199A deduction, resulting in $175,000 more in reportable taxable income for the surgeon. Recall that the two pre-deduction reported business incomes were only $120,000 apart.

Planning Considerations:
Smaller Wages, Greater Profits: Despite the rules put in place that are designed to prevent professionals from ‘gaming the system,’ expect more professionals to lower their wage/salary income below the threshold earnings levels in order to be able to claim the 20% IRC 199A deduction. A 20% tax deduction, even when limited or constrained by the 50%/2.5% adjusted basis ceilings, results in a large income tax savings, which will not be ignored by professionals.
Convert to a C Corporation? A careful analysis will have to be made if continuing a business as a pass-through entity still makes sense. This will entail a comparison of conducting the business as a new C corporation faced with an income tax rate of 21%, with the new 20% IRC 199A deduction for pass-through entities. Yet another number-crunching exercise will be required in order to make this decision.
Split-Dollar Life Insurance Plans: With the lower 21% income tax rate imposed on C corporations, a business’ split-dollar life insurance plan with its key employees may make more financial sense for both the corporation and the insured employee.
Sales to Grantor Trusts: In the past few years there were lots of sales of appreciated S corporation stock to a ‘defective grantor trust’ for the shareholder’s tax planning purposes, where the appreciated assets were removed from the seller’s taxable estate, while the payment of capital gains taxes on that sale of appreciated assets was avoided. These new tax rules that apply to pass-through entities will also apply to the irrevocable grantor trusts that hold title to stock in the pass-through entity. Consequently, many of these grantor trusts that hold S corporate stock will benefit from the 20% deduction.
Constant Wage Monitoring: Managing taxable income and expenses for pass-through entities will be critical, especially for professionals who may approach the $157,000 (for single taxpayers) or the $315,000 (for joint filers) thresholds on wage earnings to be able to claim the IRC 199A deduction.

Conclusion: I suppose I should apologize for some of my editorial comments that infrequently appear above. Please forgive my cynicism. While I see some areas of simplicity that will arise from the new tax law, I also see an enormously complicated series of calculations required to determine if a pass-through entity is entitled to claim a 20% deduction from its ‘profits.’ I also see serious threat to local charities that are dependent upon the philanthropy of the middle-class, where millions in charitable contributions may well disappear if no income tax charitable deduction will be used by those middle-class donors- almost all of whom will fall under the ‘doubled’ standard deduction. I really don’t see this as a Christmas Gift to the Middle Class as many in Washington DC have promised. What alarms me the most is that this new tax law was voted upon in haste using a self-imposed artificial deadline, with few in Congress actually understanding the fundamental elements of the law and its possible repercussions to the federal deficit over the next 8 years. With all those reservations about the law and who it ultimately impacts, we have an obligation to advise our clients on how to best take advantage of the new tax law. Hopefully you will find this remotely helpful in that regard.