The House Committee on Ways and Means has approved a bill named the Tax Cuts and Job Act, dated November 6, 2017. It then passed in the House on November 16, 2017. Our opinion is that Congress can do a much better job and shouldn’t rush this bill. So, read below and you can be the judge of our thoughts.
Congress appears eager to enact a major tax reform law that could potentially make fundamental changes in the way individuals and families calculate their federal income tax bill and the amount of federal tax that will be paid. However, will it pass the Senate, which has a different version, and be signed by President Trump? Based on Congress’ recent track record, the passing of the bill isn’t assured. This memorandum was written by Peter DeGregori, CPA, CGMA, and MST, based on his interpretation and summary of the section that effects business owners and individuals. This memo does not discuss the entire bill, nor does it provide summary or opinion on all sections.
As you have read, there are some substantial tax changes and depending on where you live and how you earn your income, the proposed changes can either be advantageous or provide negative consequences. One should consider the proposed changes for possible change to your income tax strategy. Keep in mind, however, that while most experts expect a major tax law to be enacted this year, it’s by no means a sure bet. So, keep a close eye on the news and don’t act prematurely until the ink is dry on the President’s signature on the tax reform bill. For example, there are still multiple discussions of not passing a tax cut for the wealthy (they need to define wealthy) and the possible change of not allowing state and local taxes (SALT) to be deducted. The removal of the SALT deduction is a BIG issue for Congress and the Senate to discuss, which negatively effects taxpayers in states with high income taxes like California, New Jersey, Illinois, and New York. Some tax experts and economists, can argue that the deductions of state taxes are a way to adjust for the cost of living differences throughout the United States. Also, one must understand that one of the basic principles of tax law is to not double tax income, so one could argue taking away the SALT deduction goes against the basic principal of double taxation. Never-the-less, the proposal for the removal of SALT deduction is causing a BIG discussion.
Most of the proposed changes below begin after 12/31/2017, which would mean the 2018 tax returns would be affected, but one must look at each specific provision of the final bill signed by the President to determine the effective date.
Lower tax rates coming. Both the tax bill passed by the House of Representatives and the one before the Senate would reduce tax rates for many taxpayers, effective for the 2018 tax year. (Thus, the tax rates currently wouldn’t reduce the 2017 taxes.) Additionally, businesses may see their tax bills cut, although the final form of the relief isn’t clear right now. However, depending on how you earn your income and which state you reside in, you might not be receiving a tax deduction. Hence the reason for more continued debate.
If you feel confident that a tax bill will eventually be passed and there will be reduced tax rates, then the general plan of action to take advantage of lower tax rates next year would be to defer income into next year. Some possibilities follow:
- If you are an employee who believes a bonus is coming your way before year end, consider asking your employer to delay payment of the bonus until next year.
- If you are thinking of converting a regular IRA to a Roth IRA, postpone your conversion until next year. That way you’ll defer income from the conversion until next year and hopefully have it taxed at lower rates.
- If you run a business that renders services and operates on the cash basis, the income you earn isn’t taxed until your clients or patients pay. So, if possible, hold off on billings until next year—or until so late in the year that no payment can be received in 2017. However, you need to consider the cash flow of your business. Remember cash is still King in a business.
- If your business is on the accrual basis, deferral of income till next year is difficult but not impossible. For example, you might, with due regard to business considerations, be able to postpone completion of a job until 2018, or defer deliveries of merchandise until next year. Taking these ideas into consideration could postpone revenue recognition. However, again, consider the effect on your financial statements and any bank covenants or EPS requirements. Accrual rules in this area are more complex and may require a tax professional’s input.
- The reduction or cancellation of debt generally results in taxable income to the debtor. So, if you are planning to make a deal with creditors involving debt reduction, consider postponing until 2018.
Disappearing deductions, larger standard deduction: Beginning next year, both the House-passed tax reform bill and the version before the Senate would repeal or reduce many popular tax deductions in exchange for a larger standard deduction. Think about it, if Congress is going to cut tax rates, they need offsets for the tax rate reduction. Hence the argument that everyone might not be receiving a tax cut. Here’s what you can do about this right now:
The House-passed tax reform bill would eliminate the deduction for nonbusiness state and local income or sales tax, but would allow an up-to-$10,000 deduction for real estate taxes on your home. The bill before the Senate would ban all nonbusiness deductions for state and local income, sales tax, and real estate tax. If you are an employee who expects to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding on those taxes. That way, additional amounts of state and local taxes withheld before the end of the year will be deductible in 2017. Similarly, pay the last installment of estimated state and local taxes for 2017 by Dec. 31 rather than on the 2018 due date, or prepay real estate taxes on your home. Taxpayers in high tax states do not like this proposal for elimination of state and local taxes.
Neither the House-passed bill, nor the bill before the Senate, would repeal the itemized deduction for charitable contributions. But because most other itemized deductions would be eliminated in exchange for a larger standard deduction (e.g., in both bills, $24,000 for joint filers), charitable contributions after 2017 may not yield a tax benefit for many. If you think you will fall in this category, consider accelerating some charitable giving into 2017. We believe that this bill would hurt charities, as it is currently proposed. If people are not going to be able to itemize due to the larger standard deduction, then they might reduce the amount of charitable deductions given. This is another reason why we don’t like the elimination of the SALT deductions.
The House-passed bill, but not the one before the Senate, would eliminate the itemized deduction for medical expenses. If this deduction is indeed chopped in the final tax bill, and you are able to claim medical expenses as an itemized deduction this year, consider accelerating “discretionary” medical expenses into this year. For example, order and pay for new glasses, arrange to take care of needed dental work, or install a stair lift for a disabled person before the end of the year. However, most taxpayers in our practice are not able to receive a deduction for medical expenses, as they must exceed 10% of their adjusted gross income (AGI), so keeping this deduction and eliminating the SALT deduction would again make it very difficult for one to deduct their out-of-pocket medical deductions. We didn’t read about a law in the House bill to allow taxpayers to deduct medical insurance, which if Congress wants us all to have health insurance, and the cost continues to go up, we think they should allow a tax deduction.
Other year-end strategies. Here are some other “last minute” moves that could wind up saving tax dollars in the event tax reform is passed:
The exercise of an incentive stock option (ISO) can result in Alternative Minimum Tax (AMT) complications. But both the Senate and House versions of the tax reform bill call for the AMT to be repealed next year So if you hold any ISOs, it may be wise to hold off exercising them until next year.
AMT Thought: One must remember that AMT was created in 1969, when Congress noticed that many wealthy taxpayers were taking so many deductions that they were paying very low-income tax or no income tax. They created AMT is a parallel taxing system which added back certain deductions and tried to keep taxpayers effected by AMT to pay tax at a 28% tax rate. So, why is Congress proposing to remove it? Maybe they feel it isn’t needed if they remove the majority of itemized deductions. However, taxpayers could still donate a large amount to charity, receive a deduction, and not be hit with AMT if the AMT tax is repealed. Thus, I’m not sure they need to remove it. However, AMT was created for the wealthy taxpayers, but they haven’t adjusted the formula so taxpayers with incomes of $120,000 for single or $150,000 for married are being negatively affected by AMT, so we think AMT should stay but increase the AMT trigger to be something closer to $500,000 or $1,000,000 but don’t eliminate it.
If you’ve got your eye on a plug-in electric vehicle, buying one before year-end could yield you an up-to-$7,500 discount in the form of a tax credit. The House-passed bill, but not the one before the Senate, would eliminate this credit after 2017. This proposed tax bill doesn’t support a cleaner technology, so we think Congress should reconsider.
If you’re in the process of selling your principal residence and you wrap up the sale before year end, up to $250,000 of your profit ($500,000 for certain joint filers) will be tax-free if you owned and used the property as your main home for at least two of the five years before the sale. However, under the House-passed bill and the bill before the Senate, the $250,000/$500,000 tax free amounts would apply to post-2017 sales only if you own and use the property as your main home for five out of the previous eight years. If you are in process of selling your primary residence and it wouldn’t be sold until next year (2018), make sure you can meet the expected tax law change of living in the primary residence 5 out of 8 years. If you can meet that requirement, then you shouldn’t have to be concerned with the proposed tax law change.
Under current rules, alimony payments generally are an above-the line deduction for the payor and included in the income of the payee. Under the House-passed tax bill but not the version before the Senate, alimony payments would not be deductible by the payor or includible in the income of the payee, generally effective for any divorce decree or separation agreement executed after 2017. So if you’re in the middle of a divorce or separation agreement, and you’ll wind up on the paying end, it would be worth your while to wrap things up before year end if the House-passed bill carries the day. On the other hand, if you’ll wind up on the receiving end, it would be worth your while to wrap things up next year.
Both the House-passed bill and the version before the Senate would repeal the deduction for moving expenses after 2017 (except for certain members of the Armed Forces), so if you’re about to embark on a job-related move, try to incur your deductible moving expenses before year-end.
Please keep in mind that we have described only some of the year-end considerations that should be considered in light of the tax reform package currently before Congress.
Now, let me provide some additional highlights which I feel would be of interest to our clients. Again, remember these are all currently in bills, proposed or being discussed, none of this is law, until President Trump signs a final bill:
- Carried Interest: Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, regardless of whether or not they contributed any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance. The Senate Finance Committee (SFC) is considering changing the holding period requirements. The SFC would impose a 3-year holding period requirement for certain partnership interests received in connection with the performance of services to qualify as long-term capital gain rather than ordinary income.o Personally, we think the house and Senate could have gone father. We think they should have made all the carried interest ordinary income which would be similar to the approach utilized with financial advisors and managing partners of real estate funds. We don’t know why this area of law that benefits hedge fund managers shouldn’t be repealed. It doesn’t make sense to be to provide them a benefit against other advisors in similar industries.
- 100% Meals Deduction: Disallowance of deduction for meals provided at convenience of employer. The SFC Amendment added an effective date for the provision described in the modified Chairman’s mark—the disallowance of deductions for meals provided at the convenience of the employer would apply to tax years beginning after Dec. 31, 2025.
• Individual Tax Rate Change: Consolidates the current seven tax brackets into four, with rates of 12 percent, 25 percent, 35% and 39.6%. (Table 1):
Current Law / Tax Rates: Proposed Tax Rates
|Current Law / Tax Rates:
||Proposed Tax Rates
Under the Tax Cuts & Job Act
These proposed tax rate changes for individuals don’t seem overly exciting to us.
- Increases the standard deduction from $6,350 to $12,200 for singles, from $12,700 to $24,400 for married couples filing jointly, and from $9,350 to $18,300 for heads of household. This seems to help individuals that wouldn’t have itemized deductions over the increased standard deduction, but not the taxpayers that do.
- Mortgage Interest Deduction: The proposal modifies the home mortgage interest deduction in the following ways. First, under the proposal, only interest paid on indebtedness used to acquire, construct or substantially improve the taxpayer’s principal residence may be included in the calculation of the deduction. Thus, under the proposal a taxpayer receives no deduction for interest paid on indebtedness used to acquire a second home.o Second, under the proposal, a taxpayer may treat no more than $500,000 as principal residence acquisition indebtedness ($250,000 in the case of married taxpayers filing separately).o In the case of principal residence acquisition, indebtedness incurred before the date of introduction (November 2, 2017), this limitation is $1,000,000 ($500,000 in the case of married taxpayers filing separately).o Last, under the proposal, interest paid on home equity indebtedness is not treated as qualified residence interest, and thus is not deductible.o Again, we think this is another law that sort of allows some cost of living adjustment, in which a home in a section of the country that costs more, would allow the taxpayer a larger deduction. We think Congress should keep the law as-is.
- Eliminates the personal exemption. Creates a $300 personal credit, along with a $300 non-child dependent personal credit, in place for five years. Most wealthy individuals can’t utilize the personal exemptions, so I don’t understand why they are proposing to eliminate this deduction.
- Increases the child tax credit to $1,600, with $1,000 of the tax credit initially refundable. The refundable portion is indexed to inflation until the full $1,600 is refundable. The phaseout threshold for the child tax credit is also increased: for married households, it rises from $110,000 to $230,000.
- We discussed the mortgage interest above, but as a reminder, the proposed bill retains the mortgage interest deduction, but with a cap of $500,000 of principal on newly- purchased homes. If you recall, the previous principal cap was $1,000,000. So, if you have a mortgage over $500,000 before the tax law passed, you could deduct interest on a loan of up to $1,000,000 however, the itemized deductions laws would be significantly changed.
- Retains charitable contribution deductions.
- Elimination of non-business state and local tax (SALT) but would allow property tax deduction up to $10,000.
- Eliminates the individual alternative minimum tax. This one seems exciting, but people they are eliminating the state and local tax which is generally one of the largest add backs for AMT, the elimination of AMT isn’t that appealing as discussed above, but it does cut down on alternative calculations. This seems to be a benefit for the IRS more than the taxpayers on main street.
- Alimony: The House bill, but not the Senate version, proposes to not allow a deduction against AGI and doesn’t require the recipient to include the income. This doesn’t seem fair to us. Let’s see if they change it. We have seen many divorced couples and the one paying the alimony doesn’t like it, but the pain seems to be made a little better if there is a tax deduction. Also, if the taxpayer receiving alimony isn’t it sort of like income and why shouldn’t it be taxable? We think they need to leave this one alone.
- Plug-In Credit: The proposal repeals the credit for plug-in electric drive motor vehicles. If this passes, then the credit on plug-in automobiles would be gone. Again, this goes against the clean air and climate change that government is trying to support.
- Student Loan Interest deduction would be repealed. Most deductions individual deductions seem to be appealed due to the larger standard deduction and reduced income tax rates. If a student has a large loan, the deduction for the interest can be helpful, but one needs to remember that if the taxpayer is wealthy, the interest might not be deductible anyway under current law.
- Residential Solar: There seems to be no change to the residential solar tax credit. IRC Section 25D provides a personal tax credit for the purchase of qualified solar electric property and qualified solar water heating property that is used exclusively for purposes other than heating swimming pools and hot tubs. The credit is equal to 30 percent of qualifying expenditureso In the case of qualified solar electric property and solar water heating property, the credit expires for property placed in service after December 31, 2021. In addition, the credit rate for such solar property is reduced to 26 percent for property placed in service in calendar year 2020 and to 22 percent for property placed in service in calendar year 2021.
As we have heard President Trump discuss, his overall goal has been to reduce income taxes on US businesses to spur the US economy. So, below are the proposed changes.
- International: Elimination of U.S. tax on reinvestments in U.S. property. Under current law, a foreign subsidiary’s undistributed earnings that are reinvested in U.S. property are subject to current U.S. tax. The bill would amend Sec. 956(a) to eliminate this tax on reinvestments in the United States for tax years of foreign corporations beginning after Dec. 31, 2017. This provision would remove the disincentive from reinvesting foreign earnings in the United States.
- Repatriation provision: The bill would amend Sec. 956 to provide that U.S. shareholders owning at least 10% of a foreign subsidiary will include in income for the subsidiary’s last tax year beginning before 2018 the shareholder’s pro rata share of the net post-1986 historical earnings and profits (E&P) of the foreign subsidiary to the extent that E&P have not been previously subject to U.S. tax, determined as of Nov. 2, 2017, or Dec. 31, 2017 (whichever is higher). The portion of E&P attributable to cash or cash equivalents would be taxed at a 12% rate; the remainder would be taxed at a 5% rate. U.S. shareholders can elect to pay the tax liability over eight years in equal annual installments of 12.5% of the total tax due.
- Estate Tax: The proposal doubles the estate and gift tax exemption amount for decedents dying and gifts made after December 31, 2017. This is accomplished by increasing the basic exclusion amount provided in section 2010(c)(3) of the Code from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011.o For estates of decedents dying and generation-skipping transfers made after December 31, 2023, the proposal repeals the estate tax and the generation- skipping transfer tax. The proposal includes a transition rule for assets placed in a qualified domestic trust by a decedent who died before the effective date of the proposal. Specifically, estate tax will not be imposed on: (1) distributions before the death of a surviving spouse from the trust more than 10 years after the date of enactment; or (2) assets remaining in the qualified domestic trust upon the death of the surviving spouse. The top marginal gift tax rate is reduced to 35 percent for gifts made after December 31, 2023.o The proposal generally retains the present law rules for determining the income tax basis of assets acquired by gift and assets acquired from a decedent. As a result, property received from a donor of a lifetime gift generally will continue to take a carryover basis, and property acquired from a decedent’s estate generally will continue to take a stepped-up basis.o We think this one might be revised as the public sees it as creating a benefit for the wealthy.o Effective dates: The proposal to double the estate and gift tax exemption is effective for estates of decedents dying, generation-skipping transfers, and gifts made after December 31, 2017. The repeal of the estate and generation- skipping transfer taxes, and the reduction in the gift tax rate to 35 percent, are effective for estates of decedents dying, generation-skipping transfers, and gifts made after December 31, 2023.
Tax-Exempt Entities: The proposed changes by the house include a slight modification for UBTI.
- Under the proposal, unrelated business taxable income includes any expenses paid or incurred by a tax-exempt organization for qualified transportation fringe benefits (as defined in section 132(f)), a parking facility used in connection with qualified parking (as defined in section 132(f)(5)(C)), or any on-premises athletic facility (as defined in section 132(j)(4)(B)), provided such amounts are not deductible under section 274.
Suggestions for Congress:
- Unfortunately, this bill isn’t going to make everyone happy, but if they want to increase jobs and provide the people on main street tax benefits, we feel Congress can consider other items.
- I think Congress can still allow the state and local tax deduction, and consider maybe a limit or cap on large taxable income. Maybe at least $1,000,000 or more. Removing the SALT deduction will hurt a lot of taxpayers in states with high tax rates and most of these states have a much larger cost of living. Congress needs to reduce deductions to offset reduce tax rates but reducing tax rates and reducing deductions is probably going to keep a lot of taxpayers in the middle class at the same amount of tax or more.
- Consider removing the carried interest tax benefit beginning in 2018. You will read above, that we do not feel it is fair that managers of hedge funds or private equity get a reduced tax rate compared to financial advisors or managers of real estate funds.
- Consider increasing the net investment income tax (NIIT) rate on investment income, but increase the threshold of when the NIIT is applied. We think applying the NIIT to taxpayers below $500,000 of taxable income isn’t fair.
- Consider keeping itemized deductions and allow taxpayers to deduct health insurance costs as the government wants us to have it.
- If you keep itemized deductions, AMT needs to stay, but increase the threshold amount. Taxpayers making less than $400,000 shouldn’t be hit with AMT.
- Consider removing the benefit of deducting the intangible drilling costs for oil and gas. If the US is trying to move to clean and renewalable energy, then the US should consider if they need to keep a tax benefit for oil and gas investments.
- Consider increasing the long-term capital gains rate for taxpayers with very large investment income.
- Do not carve out professional service business from the 25% tax rate for pass throughs. Those companies create jobs also, and if the goal is to increase the jobs in America and spur the economy, then all businesses should be treated the same regardless of industry. This is what the Senate proposed, and we agree with the Senate. Also, if you compare a professional service company with a manufacturing company that is labor intensive, both companies utilize labor, but because one company charges for labor and one company sells a good, why should the tax rate be different?
- Consider not removing the Estate tax and also consider if you really need to increase the Estate exemption from $5,000,000 to $10,000,000.
- Consider removing not for profit status for professional sports leagues.
- Consider examining not for profit entities much more. For example, let’s look at all the news about the Clinton Foundation. Are they really meeting the not for profit status that other charities are required to meet?
- Cut costs. Although not part of the tax bill. Government waste’s money, and they really need to look at cutting costs. Congress needs to make difficult decisions that is for the best of the countries fiscal strength. Why does the USA have such a large deficit? Congress can and is responsible for the deficit.
- Congress needs to abide by all laws they pass. Is there a valid reason why Congress can be exempt from the Affordable Care Act? They created it. If it was so good for the country, they should be required to live by their own laws.
- Congress needs to consider continuing education just like doctors, lawyers, and accountants. I think they need mandatory ethic’s and receive continuing education on items that would help them do a better job. Maybe like accounting, finance, law, sexual harassment, and maybe the ability to fully understand more complex laws they have past. Professionals and businesses need to deal with it, why not Congress? If we look at their track records, the deficit, I don’t think anyone would agree they would be getting an “A”.
Again, I think Congress can do a much better job. Well, we will have to wait and see what Congress and President Trump decides. If you would like more details about any aspect of how the proposed legislation may affect you, please contact Peter DeGregori, CPA at 949-756-8080. Or find us at www.verticaladvisors.com.
To ensure compliance with requirements imposed by the IRS, we inform you that any US federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and it cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. If you are not the original addressee of this communication, you should seek advice based on your particular circumstances from an independent advisor.