The 2017 Tax Act brought sweeping changes for families and businesses. It will take some time before we see the full impact of tax reform given its complexities and limitations. Except for the corporate tax rate and several other provisions, the new tax rules are set to expire effective 2026 and will revert back to what they were before the 2017 Tax Act went into effect. Part 1 of the Tax Reform Spotlight series will provide a general overview of the new law.
Doubling of Standard Deduction & Child Tax Credit
In a nutshell, the income tax rates have been lowered, and most households and businesses will see a decrease in their tax rate. However, because the reform bill also includes limitations on a number of commonly used deductions, the tax rate decreases will be offset, in many cases, by the loss of the deductions. Moreover, because the new law doubles the standard deduction—now $12,000 Single filers(S), $18,000 Head of Household filers (HOH) and $24,000 Married Filing Jointly(MFJ)— most taxpayers who would normally itemize to take advantage of available deductions will opt to use the standard deduction instead. Therefore, the new deduction limitations, relating to mortgage interest and SALT deductions mentioned below, for example, may be moot.
Note that the personal exemption deduction of $4,050 for each eligible dependent has been eliminated while the child tax credit has been doubled to $2,000 per qualifying child under age 17. The child tax credit now has broader applicability given the higher income phase-out thresholds—the point where the credit is limited or disallowed. That is, the phase-out threshold has been increased to $400,000 for joint filers (up from $110,000) and $200,000 for single filers (up from $75,000). There is also an increase in the refundable portion from $1,000 to $1,400.
Lowering of Individual & Corporate Rates
Overall, the individual income tax rates have been lowered with the top marginal rate dropping from 39.6% to 37%. The corporate tax rate has dropped significantly, from a flat 35% to 21%.
Planning Touch Point: We should see significant interest by companies considering executive benefits planning, such as non-qualified plans and key man coverage, from this lower rate since it makes after-tax planning much more attractive.
The individual AMT tax exemption amounts– and the phase out of that exemption amount based on income— have been expanded, resulting in a net effect of lowering, if not eliminating, AMT tax for those individuals subject to the tax. Meanwhile, the corporate AMT tax has been eliminated entirely and will not be subject to expiration in 2026.
SALT Deduction Limits
An individual taxpayer is now limited in the amount that can be deducted for the payment of state and local income, sales and property taxes (SALT). The deduction for all of these items combined is capped at $10,000 ($5,000 for married single filers).
Planning Touch Point: This means that those high-income individuals in high income tax states like NJ, NY, CA, OR, WI, to name a few, might consider restructuring property ownership through the use of trusts established in more tax-friendly states, depending on the resident state’s long arm statute.
Planning Touch Point: Wealthier donors may want to consider bunching up on their charitable gifts in order to be able to itemize deductions all in one year now that the State tax deduction is limited. Further, by using a Donor-Advised Fund, for example, the taxpayer can decide later which charities to allocate the “bunched up” gifts.
Planning Touch Point: For wealthier clients who are subject to IRA required minimum distributions, making a gift of an unneeded IRA direct to charity may make sense. In this way, the gift avoids the tax return and lowers overall income. The maximum amount of a charitable IRA rollover allowed continues to be $100,000.
Relative to businesses, the SALT deductions are allowed when paid or accrued in carrying on a trade or business, or when related to expenses connected to the production of income.
Mortgage Interest Deduction
Mortgage interest paid on a primary or secondary home continues to be deductible but only up to $750,000 of debt. Prior law allowed the mortgage debt to be up to $1 million. However, no equity line interest deduction is allowed any longer– regardless of the purpose of the equity line.
Distributions of up to $10,000 may now be used for “qualified expenses” for elementary school and high school. Prior, 529 funds could only be used for post-secondary “qualified educational expenses”, such as tuition, room & board and books.
20% Deductibility of Business Income By Pass-Throughs
Small businesses that do not operate as a C-corporation and instead “pass- through” their qualified business income (QBI) to their individual tax return, may now be eligible to deduct 20% of QBI. Sole proprietorships, and partnerships set up as limited liability companies (LLC) or Family Limited Partnerships (FLP) may be able to take advantage of this new rule. However, there are complex rules that govern the extent of the tax benefits and the limitations based on type of service business.
Effectively, those pass-throughs that can actually use the 20% deduction will effectively pull their new top rate of 37% down to 29.6% when using the 20% deductibility in full. However, certain service businesses structured as pass throughs– such as law firms, accounting firms, investment firms and physician practice– can take advantage of the 20% write-off only if taxable income is less than $315,000(MFJ), or $157,500(S). That is, the 20% deduction is phased out over the next $100,000(MFJ) and $50,000(S) of taxable income, respectively— after which no deduction is allowed for these firms.
Interestingly, a special exception was made for architect and engineering firms so that their deduction is not limited by the amount of the taxable income. In addition, commercial real estate owners and operators will benefit greatly under these new rules, on many levels.
Business Interest Deduction
Business interest expense refers to interest paid on business debt, such as a mortgage or debt incurred to purchase inventory, for example. The Tax Act limits a business’s net interest expense deduction to 30% of the taxpayer’s “adjusted taxable income”. Adjustable taxable income is computed without regard to deductions allowable for depreciation, amortization and depletion. Interest deductions which are capped by this rule can be carried forward indefinitely, subject to the same annual interest deduction limitations.
Note that businesses with an average of not greater than $25 million in gross receipts for the immediately pre-ceding three-year period continue to be exempt from any limits on their business interest expenses, regardless of depreciation schedule.
Higher Transfer Tax Exemption Amounts
Estates can shelter a certain amount of gifts, during lifetime or at death, from estate, gift and Generation-skipping (GST) taxes. We refer to these amounts as the lifetime exemption amount or the applicable exclusion amount. Prior to the Tax Act, the exemption amount was $5.5 million per individual ($11.2 million per married couple). The exemption has now doubled under the new law, pegged at approximately $11.18 million per person (or $22.36 million per married couple). This higher amount leaves very few estates subject to the estate tax.
Planning Touch Point: Although the higher exemption is good for estate tax relief, clients would be well advised to not have a false sense of confidence in their planning to-date–as the higher exemption provides no benefits for their many non-tax needs.
The exemption amount is indexed for inflation based on the new chained-CPI method, which slightly lowers the impact of indexing. Clarification of the exact amount based on this new method of indexing should be forthcoming. Subject to certain exceptions, gifts, estates, and GST transfers in excess of the $11.18 million (or $22.36 million per married couple) will continue to be taxed at a 40% rate.
Planning Touch Point: To be clear, the exemption expires in 2026, at which point this exemption will revert back to pre-tax act exemption amount, indexed for chained CPI, and estimated to be approximately between $6.3 – $6.5 million in 2026. Planning should take into account this ‘sunset’ exemption, in addition to the size of a client’s current estate, its expected growth, and the age and health of the client. Moreover, liquidity needs to equalize gifts among heirs, as well as to create opportunity for heirs to buy each other out of unwanted assets, must be considered carefully.
Revisiting Step-Up in Basis
Notably, after much concern that the step-up in basis rules would go away with tax reform, no changes were made to the rule. Individuals transferring property at death continue to receive a step-up to fair market value on property that ultimately transfers to heirs.
Planning Touch Point: Planning practitioners weigh estate tax costs associated with property transfers at death with the loss of step-up in basis when property is transferred during lifetime and often opt to forego the step-up in favor of saving estate tax. Because many more families will no longer be subject to the estate tax –at least temporarily—preserving the step-up will be a priority exercise by practitioners. Accordingly, we may now see more loaning or renting out of family assets or cash in the next 7 years—in lieu of making outright lifetime transfers. This planning approach will not only preserve the step-up in basis, but will also provide tremendous flexibility while also providing a premium funding vehicle to address a family’s life insurance needs.
Stay Tuned for Part 2 in which we address some winners and losers of tax reform.