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Tax Reform Now: Part 11

December 27, 2017 CSBB Blog

On December 20, 2017, the Senate and House of Representatives passed the same tax bill, which opened the door for President Trump to deliver significant changes to the United States tax code. The Senate passed the tax bill by a vote of 51-48. The House of Representatives passed the tax bill by a vote of 224-201. No Congressional Democrats voted in favor of this partisan tax bill. On December 22, 2017, President Trump officially signed the tax bill into law. Most of the changes will be implemented starting in 2018.

At the outset, it should be noted that the tax bill makes certain changes temporary for individuals in order to comply with the budget reconciliation rules. President Bush passed tax cuts in 2001 and 2003 using budget reconciliation. The budget reconciliation rules allowed the Senate Republicans to pass this tax bill by a simple majority vote. A tax bill passed by the Senate through budget reconciliation must satisfy the Byrd Rule, which requires that the tax bill cannot increase the federal deficit after ten years. Therefore many of the provisions affecting individual and estate and gift taxation will “sunset” (in essence, expire) after 2025. This newsletter will focus on certain provisions in the tax bill that significantly affect individuals, corporations, pass-through businesses, estates, and trusts.

Individuals

The new tax bill retains seven income tax brackets for individuals, but it will change the income tax rates. Starting on January 1, 2018, the seven income tax brackets will be 10%, 12%, 22%, 24%, 32%, 35%, and 37%. To comply with the budget reconciliation rules, these new income tax rates will sunset after 2025. Under the new tax bill, the personal exemption is repealed, and the standard deduction increases to $12,000 for single individuals and $24,000 for joint filers.

Single Individuals

If taxable income is The income tax is equal to
Not over $9,525 10% of taxable income
Over $9,525 but not over $38,700 $952.50 plus 12% of the excess over $9,525
Over $38,700 but not over $82,500 $4,453.50 plus 22% of the excess over $38,700
Over $82,500 but not over $157,500 $14,089.50 plus 24% of the excess over $82,500
Over $157,500 but not over $200,000 $32,089.50 plus 32% of the excess over $157,500
Over $200,000 but not over $500,000 $45,689.50 plus 35% of the excess over $200,000
Over $500,000 $150,689.50 plus 37% of the excess over $500,000

Heads of Households

If taxable income is The income tax is equal to
Not over $13,600 10% of taxable income
Over $13,600 but not over $51,800 $1,360 plus 12% of the excess over $13,600
Over $51,800 but not over $82,500 $5,944 plus 22% of the excess over $51,800
Over $82,500 but not over $157,500 $12,698 plus 24% of the excess over $82,500
Over $157,500 but not over $200,000 $30,698 plus 32% of the excess over $157,500
Over $200,000 but not over $500,000 $44,298 plus 35% of the excess over $200,000
Over $500,000 $149,298 plus 37% of the excess over $500,000

Married Individuals Filing Joint Returns and Surviving Spouses

If taxable income is The income tax is equal to
Not over $19,050 10% of taxable income
Over $19,050 but not over $77,400 $1,905 plus 12% of the excess over $19,050
Over $77,400 but not over $165,000 $8,907 plus 22% of the excess over $77,400
Over $165,000 but not over $315,000 $28,179 plus 24% of the excess over $165,000
Over $315,000 but not over $400,000 $64,179 plus 32% of the excess over $315,000
Over $400,000 but not over $600,000 $91,379 plus 35% of the excess over $400,000
Over $600,000 $161,379 plus 37% of the excess over $600,000

Estates and Trusts

If taxable income is The income tax is equal to
Not over $2,550 10% of taxable income
Over $2,550 but not over $9,150 $255 plus 24% of the excess over $2,550
Over $9,150 but not over $12,500 $1,839 plus 35% of the excess over $9,150
Over $12,500 $3,011.50 plus 37% of the excess over $12,500

Although most itemized deductions are now eliminated, the status of certain itemized deductions are worth mentioning. Beginning in 2018, an individual can take a deduction of up to 60% of the individual’s adjusted gross income for cash contributions made to public charities or certain private foundations if the individual itemizes his or her deductions. This new increase is only beneficial to those individuals who will itemize their deductions under the new tax bill. The increased charitable deduction sunsets after 2025. That is, after 2025, an individual can take a deduction of up to 50% of the individual’s adjusted gross income for cash contributions made to public charities or certain private foundations.

The tax bill repeals the alimony payment deduction. As a result, alimony payments will no longer be included in gross income by the recipient, nor will the payments be deductible by the payor. The effective date of the repeal is delayed by one year. Thus, the new tax treatment for alimony payments will apply to any divorce or separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before December 31, 2018, and modified after that date, if the modification expressly provides that the new rule created by the tax bill applies to the divorce or separation instrument.

Some itemized deductions will be scaled back. A married joint filing taxpayer can now claim an itemized deduction of up to $10,000 for state and local property taxes and either state and local income or sales taxes. The taxpayer can elect any combination of those taxes to reach the $10,000 cap. The tax bill prohibits a taxpayer from taking a deduction resulting from prepaying state and local income taxes for taxable years beginning in 2018. The new state and local tax deduction rules sunset after 2025.

Many taxpayers deduct the mortgage interest on their homes. Under the current law, interest incurred on up to $1 million of mortgage debt is deductible. The current home mortgage interest deduction rules will apply to all mortgages entered into before December 15, 2017.  However, the home mortgage interest deduction will be scaled back for home mortgages entered into after that date. Under the tax bill, a taxpayer can deduct interest incurred on up to $750,000 of mortgage debt on a home purchased after December 15, 2017. Furthermore, a taxpayer can no longer take a deduction for interest on home equity indebtedness.

There are a few other items affecting individuals which are noteworthy. Under the Affordable Care Act, individual taxpayers have been required to purchase a health plan that provides minimum essential coverage or be subject to a penalty tax for failing to maintain suitable coverage. This penalty tax is imposed on a taxpayer for any month he or she does not have minimum essential coverage unless he or she qualified for an exemption. The tax bill eliminates the penalty tax for taxpayers who fail to buy health insurance beginning in 2019. Additionally, although discussed and contained in several of the proposed versions, the tax bill did not end up including a provision requiring the first-in-first-out method for determining the cost basis of securities, which would have eliminated a taxpayer’s ability to specifically identify which securities were sold.

Corporations

Corporations are the biggest beneficiaries under the new tax bill. The corporate tax rate will be lowered from 35% to a flat 21% rate starting in 2018. Unlike the new individual income tax rates, the corporate income tax rate change is permanent. Additionally, the corporate alternative minimum tax is repealed. The tax bill scales back a corporation’s dividend received deduction. If a corporation owns more than 20% of the distributing corporation’s stock, the corporation can deduct 65% of the dividends received. If a corporation owns less than 20% of the distributing corporation’s stock, the corporation can deduct 50% of the dividends received.

Provisions Applying to All Business Entities

All businesses will be allowed to immediately deduct the entire cost of investment in “qualified property” acquired and placed in service after September 27, 2017 and before January 1, 2023. This 100% deduction phases out between 2023 and 2026. Unlike the existing law, a business will be able to deduct the entire cost of newly purchased used property. “Qualified property” includes all depreciable property and certain qualified film, television, and live theatrical productions (as defined in Section 181(d) and (e)). However, “qualified property” does not include any property used in a real property trade or business.

Under the current Section 1031, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a “like kind” which is to be held for productive use in a trade or business or for investment. Section 1031 will be modified to only allow nontaxable like-kind exchanges of real property not held primarily for sale. The new rule will apply to exchanges completed after December 31, 2017. After that date, a taxpayer can no longer defer gain recognition on non-real property by engaging in a like-kind exchange.

Pass-Through Business Deduction

Sole proprietorships, partnerships, limited liability companies, and S corporations are generally treated as pass-through entities that are not subject to tax at the entity level. Instead, an individual owning an interest in a pass-through business is taxed on any pass-through income at their own individual income tax rate. The tax bill does not create a new maximum tax rate for pass-through business owners. However, many pass-through business owners will be able to deduct a portion of their pass-through income, which will reduce the taxpayer’s taxable income. After this deduction is taken, the individual owner will pay income taxes at the new individual income tax rates.

The tax bill adds Code Section 199A, which will allow an individual (or trust / estate) with an ownership interest in a pass-through business to potentially deduct 20% of the non-wage portion of pass-through income. The new pass-through deduction will be available starting on January 1, 2018 and sunsets after December 31, 2025. Under Section 199A(a)(1), the deduction for qualified business income is equal to the sum of

  • the lesser of the combined qualified business income amount for the taxable year or an amount equal to 20 percent of the excess of taxpayer’s taxable income over any net capital gain and qualified cooperative dividends, plus
  • the lesser of 20 percent of qualified cooperative dividends or taxable income (reduced by net capital gain).

The “combined qualified business income amount” (referred to as the “combined QBI amount” in the rest of the newsletter) consists of the deduction for each qualified trade or business plus 20% of taxpayer’s REIT dividends and qualified publicly traded partnership income (“qualified PTP income”). For simplicity’s sake, the computation for “combined QBI amount” in the newsletter will not include REIT dividends and qualified PTP income.

While reviewing this section, the reader should remember that the final “combined QBI amount” represents the amount of the potential pass-through deduction. Since this newsletter is ignoring REIT dividends and qualified PTP income, a taxpayer’s “combined QBI amount” (or potential pass-through deduction) will be the lesser of

(a) 20 percent of the taxpayer’s qualified business income with respect to the trade or business, or

(b) The greater of

(i) 50 percent of the W-2 wages with respect to the trade or business, or

(ii) The sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.

The taxpayer must initially determine the amount of “qualified business income,” which consists of the “net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business.” There are certain items which are not included in this calculation, including reasonable compensation to the taxpayer and any guaranteed payments made to the taxpayer.

After your eyes have recovered from reading the previous three paragraphs, this newsletter will attempt to describe the mechanics of the pass-through deduction in a simpler manner. Essentially, Section 199A(a)(1) allows a taxpayer to deduct the lesser of the “combined QBI amount” or 20% of the excess of taxpayer’s taxable income over net capital gain. The pass-through deduction can be confusing because a taxpayer may need to calculate their “combined QBI amount” three times using three different tests. Conquering the concept of the “combined QBI amount” is critical to understanding the pass-through deduction. This newsletter will clarify (to the best of our ability) how a taxpayer calculates the “combined QBI amount.”

Let’s start with the easiest scenarios. If a single taxpayer earns $157,500 or less of qualified business income and files a return, that taxpayer multiplies 20% by $157,500 (or less) of qualified business income. This amount represents the taxpayer’s “combined QBI amount” (unless the taxpayer also has REIT dividends and qualified PTP income). If a married joint filer earns $315,000 or less of qualified business income, that taxpayer multiples 20% by $315,000 (or less) of qualified business income. This amount represents the married joint filer’s “combined QBI amount.” Taxpayers in these income thresholds do not need to worry about the three tests described later in the newsletter. With the taxpayer’s “combined QBI amount” now calculated, the taxpayer’s actual pass-through deduction will be the lesser of this “combined QBI amount” or 20% of the excess of taxpayer’s taxable income over net capital gain. Once the pass-through deduction is taken, the taxpayer will pay income taxes on their taxable income at the new income tax rates.

A taxpayer with qualified business income between certain income levels will be entitled to a reduced pass-through deduction. The wording of the statute is confusing, but it can be synthesized into two points. A single taxpayer can take a reduced pass-through deduction if the taxpayer’s qualified business income is between $157,500 and $207,500. A married joint filer can take a reduced pass-through deduction if the taxpayer’s qualified business income is between $315,000 and $415,000.

When a taxpayer’s qualified business income exceeds the income thresholds ($157,500 for individual taxpayers and $315,000 for married joint filers) and the phase-in amounts (over the next $50,000 for individual taxpayers and $100,000 for married joint filers), Section 199A becomes difficult to follow. However, keep in mind that the rules described below only apply to a single individual taxpayer who earns more than $207,500 of qualified business income (or to a married joint filer who earns more than $415,000 of qualified business income).

For a single individual taxpayer earning more than $207,500 of qualified business income (or a married joint filing taxpayer earning more than $415,000 of qualified business income), the taxpayer must calculate the “combined QBI amount” under three tests. After a taxpayer computes the “combined QBI amount” under the three tests, the taxpayer chooses the larger “combined QBI amount” between the second and third tests. The taxpayer must then compare such “combined QBI amount” to the amount calculated under the first test. The lower amount between the first test and second (or third) test will represent the taxpayer’s “combined QBI amount.”

First Test – 20% Test

The first test can be referred to as the “20%” Test. The “20%” Test is the same test discussed above in the easiest scenarios. The taxpayer calculates their “combined QBI amount” by multiplying 20% by the amount of qualified business income. However, the taxpayer is subject to a wage limitation threshold. This threshold is intended to deter taxpayers from attempting to convert wages (or other reasonable compensation) to qualified business income eligible for the deduction. Thus, the taxpayer must now calculate the “combined QBI amount” under two other tests.

Second Test – W-2 Wages Test

The second test can be referred to as the “W-2 Wages” Test. Under the second test, the taxpayer calculates their “combined QBI amount” by multiplying 50% by the amount of the W-2 wages. Understanding this calculation is difficult without knowing the definition of W-2 wages. Under Section 199A, W-2 wages “means, with respect to any person for any taxable year of such person, the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year.” The “amounts described in paragraphs (3) and (8) of section 6051(a)” refers to the total amount of wages defined in Section 3401(a), elective deferrals, and compensation deferred under Section 457, including the amount of designated Roth Contributions. Under Section 3401(a), wages refers to “all remuneration . . . for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash . . . .” There are twenty-three exceptions to this wages definition, which this newsletter will not discuss. Once the total amount of W-2 wages are determined, the taxpayer multiples 50% by the W-2 wages to calculate the “combined QBI amount” under the second test.

Third Test – “W-2 Wages and Basis Test”

The third test can be referred to as the “W-2 Wages and Basis” Test. Under the third test, the taxpayer initially multiplies 25% by the amount of W-2 wages. The taxpayer then computes 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The taxpayer adds these two amounts together to arrive at the taxpayer’s “combined QBI amount” under the third test.

Understanding this calculation is difficult without knowing the definitions of key terms, such as W-2 wages and qualified property. W-2 wages is defined in the same manner as discussed in the second test. “Qualified property” refers to depreciable tangible property that satisfies three requirements. The depreciable tangible property must be held for use in the qualified trade or business at the close of the taxable year, was used at any point in producing qualified business income, and the depreciable period has not ended before the close of the taxable year. Each taxpayer has an “unadjusted basis immediately after acquisition of qualified property” equal to such taxpayer’s allocable share of the unadjusted basis immediately after acquisition of the qualified property.

Final Pass-Through Deduction

The reader has almost conquered the pass-through deduction. As a reminder, the “combined QBI amount” (potential pass-through deduction) is the lesser of (a) 20 percent of the taxpayer’s qualified business income with respect to the trade or business (the “20% Test”), or (b) the greater of (i) 50 percent of the W-2 wages with respect to the trade or business (the “W-2 Wages Test”) or (ii) the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property (the “W-2 Wages and Basis Test”). If a reader understands the previous sentence, then the reader has conquered the pass-through deduction.

This table may be helpful in visualizing how to determine the final “combined QBI amount.”

The final “combined QBI amount” is the LESSER of

·      20% x QBI (First test – “20% Test”) or

·      The greater of

o   W-2 wages x 50% (Second test – “W-2 Wages Test”)

o   W-2 wages x 25% + 2.5% of unadjusted basis of qualified property (Third test – “W-2 Wages and Basis Test”)

For a single individual taxpayer earning $207,500 or more of qualified business income (or $415,000 for a married joint filing taxpayer), such taxpayer’s “combined QBI amount” typically will be the largest under the first test. However, the wage limitation threshold will prevent the taxpayer from taking a deduction for this amount.[1] Instead, the taxpayer compares the “combined QBI amounts” calculated using the second and third tests. Whichever test generates the larger amount will be the taxpayer’s final “combined QBI amount.” Example 2 describes the pass-through deduction mechanics for this scenario.

At this point, the taxpayer has reached the last step of the pass-through deduction. The taxpayer’s permitted pass-through deduction will be the lesser of the final “combined QBI amount” or 20% of the excess of taxpayer’s taxable income over net capital gain. The pass-through deduction reduces the taxpayer’s taxable income, and the taxpayer will pay income taxes at the new income tax rates.

This newsletter will now discuss two simple examples applying the new pass-through deduction rules.

Example 1 – Single Individual Earning Less than $157,500 of Qualified Business Income

In 2018, a taxpayer earns $100,000 of qualified business income in a sole proprietorship. The taxpayer has $24,000 of other income. The taxpayer will take the new $12,000 standard deduction in 2018. The taxpayer’s adjusted gross income is $124,000 ($100,000 qualified business income + $24,000 other income). The taxpayer’s taxable income is $112,000 ($124,000 adjusted gross income – $12,000 standard deduction). The taxpayer’s pass-through deduction will be the lesser of the combined QBI amount calculated under the 20% Test or 20% of the taxpayer’s taxable income. Under the 20% Test, this taxpayer’s “combined QBI amount” is $20,000 (20% x $100,000 of qualified business income). Twenty percent of the taxpayer’s $112,000 of taxable income is $22,400. Since the “combined QBI amount” is less than 20% of the taxpayer’s taxable income, the taxpayer is entitled to a $20,000 pass-through deduction. This $20,000 pass-through deduction reduces the taxpayer’s taxable income to $92,000 ($112,000 taxable income – $20,000 pass-through deduction).

Example 2 – Married Individual Earning More than $415,000 of Qualified Business Income

In 2018, a married taxpayer who files a joint return earned $600,000 of qualified business income in a sole proprietorship. The taxpayer and her spouse have $44,000 of other income and $74,000 of itemized deductions in 2018. The sole proprietorship has $150,000 of W-2 wages and $1,000,000 of assets (unadjusted cost basis). The taxpayer’s adjusted gross income is $644,000 ($600,000 qualified business income + $44,000 other income). The taxpayer’s taxable income is $570,000 ($644,000 adjusted gross income – $74,000 itemized deductions). Because this taxpayer earned more than $415,000 of qualified business income, the taxpayer must calculate her “combined QBI amount” under the three tests.

  1. Under the “20%” Test, the taxpayer calculates her “combined QBI amount” by multiplying 20% by the $600,000 of qualified business income. Under the first test, the taxpayer’s “combined QBI amount” is $120,000.
  1. Under the “W-2 Wages” Test, the taxpayer calculates her “combined QBI amount” by multiplying 50% by the $150,000 of W-2 wages. Under the second test, the taxpayer’s “combined QBI amount” is $75,000.
  2. Under the “W-2 Wages and Basis” Test, the taxpayer calculates her “combined QBI amount” by first multiplying 25% by the $150,000 of W-2 wages, which equals $37,500. Next, the taxpayer multiples 2.5% by the $1,000,000 of unadjusted basis immediately after acquisition of all “qualified property,” which equals $25,000. Under the third test, the taxpayer’s “combined QBI amount” is $62,500 ($37,500 + $25,000).

The taxpayer’s final “combined QBI amount” is $75,000, which was calculated under the “W-2 Wages” Test. Although the taxpayer would have been entitled to a larger pass-through deduction under the “20%” Test, the taxpayer is subject to the wage limitation threshold. Thus, the taxpayer can only take a deduction on the larger amount calculated under the second and third tests. When comparing the second and third tests, the taxpayer receives a larger deduction under the second test. The taxpayer’s final “combined QBI amount” is $75,000.

The final “combined QBI amount” is the LESSER of

·      $120,000 – 20% x $600,000 QBI (First test – “20% Test”) or

·      The greater of

o   $75,000 – 50% x $150,000 W-2 wages (Second test – “W-2 Wages Test”)

o   $62,500 – 25% x $150,000 W-2 wages + 2.5% of $1,000,000 unadjusted basis of qualified property (Third test – “W-2 Wages and Basis Test”)

The taxpayer’s permitted pass-through deduction will be the lesser of the $75,000 final “combined QBI amount” or $114,000 (20% of the $570,000 excess of taxpayer’s taxable income over net capital gain). As a result, the taxpayer can take a $75,000 pass-through deduction. This deduction reduces the taxpayer’s taxable income to $495,000 ($570,000 taxable income – $75,000 pass-through deduction).

Certain Service Professionals Not Entitled to Pass-Through Deduction

This new pass-through deduction is not available to all pass-through business owners. A taxpayer participating in a “specified service trade or business” will generally not be able to take the pass-through deduction. A “specified service trade or business” includes a trade or business that performs services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, partnership interests, or commodities, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. Engineers and architects can breathe a sigh of relief. Unlike business owners involved in the professions listed above, engineers and architects will be entitled to take the pass-through deduction.

Even if a taxpayer is engaged in a prohibited “specified service trade or business,” that taxpayer can take the pass-through deduction if the taxpayer’s qualified business income is less than $157,500 for single filers and $315,000 for married joint filers. The pass-through deduction is calculated in the same manner as the previous section. A reduced deduction will be available if a single filer’s taxable income is between $157,500 and $207,500 and when a married joint filer’s taxable income is between $315,000 and $415,000. Once these income thresholds are surpassed, a taxpayer participating in a “specified service trade or business” is not entitled to any pass-through deduction.

Estate Tax

The tax bill does not repeal the estate tax as was discussed in the past months. Instead, the estate, gift and generation skipping transfer tax exemption amounts will double as indexed for inflation. In 2017, an individual has an estate, gift and generation skipping transfer tax exemption amount of $5,490,000. As indexed for inflation, in 2018, an individual can leave up to $11,200,000 to heirs and pay no federal estate or gift tax. A married couple will therefore be able to shelter $22,400,000 in assets. That is, couples will be able to give up to $22,400,000 during life or at death (not including annual exclusion amounts) to beneficiaries without incurring any transfer tax.

The increase in the estate, gift and generation skipping transfer tax exemption will sunset after 2025. After December 31, 2025, the estate, gift and generation-skipping transfer tax exemption will return to the current amount, as indexed for inflation [i.e., a married couple will only be able to shelter $11,200,000 in taxes as indexed for inflation]. The return of the lower exclusion amount in 2026 will have critical estate planning effects as described below.

The portability of a deceased spouse’s unused exemption is retained under the Act. Therefore, if a spouse dies before using all of his or her exemption, the surviving spouse can elect to retain his or her spouse’s remaining exemption. The higher exemption amount should not deter surviving spouses from filing a federal estate tax return as detailed below.

Planning Techniques

Estate Planning

Beginning in 2018, you should consider making gifts to or using trusts for the benefit of other family members up to the new gift tax exclusion amount.

As there are no assurances that a future administration will not lower the exemption amounts, moderately wealthy taxpayers who would benefit from the higher exemption should not defer estate planning. In particular, if your net worth is between the current exclusion amount and that which will be effective next year, you should consider seizing on what may be only a temporary increase in exemption amounts. For instance, if you are married and your net worth is $18,000,000, you should consider estate planning techniques to assure your use of the higher exclusion. Although overly simplified, if you did not take any action to use the additional credit, when the transfer tax exemptions return in 2026 to the current amount, as indexed for inflation, your estate will pay up to $2,720,000 in tax that could have been avoided. [$18,000,000 – $11,200,000 [the exemption for 2018 as indexed for inflation, before the act passed] = $6,800,000; $6,800,000 x 40% [the current estate tax rate] = $2,720,000.

Individuals with a net worth higher than the 2018 exclusion amount should also consider planning in order to take advantage of the new exemption amount to leverage larger wealth transfers.

Income Tax Planning

Income tax planning will be increasingly popular with respect to generational wealth shifting for the next eight years. Take the following scenario as an example. A husband dies in 2004 owning a piece of property with a value of $200,000. Pursuant to the husband’s estate planning documents, the property is devised to a credit shelter trust for the benefit of husband’s wife. The new basis of the property is $200,000 (the value of the property at husband’s death). By 2018, when the wife dies, the property is worth $1,000,000. The property in the family trust would still have a basis of $200,000. Therefore, if the property is sold following the wife’s death, gain would be $800,000 ($1,000,000-200,000). However, if prior to the wife’s death, the trust is decanted into a new trust giving the wife a general power of appointment, the trust would be included in the wife’s estate. Therefore, the property would receive a step-up in basis to $1,000,000. Decanting the property into a trust over which the wife has a general power of appointment could save $160,000 of income tax ($800,000 x 20% capital gain tax).

Portability

If your net worth now does not exceed the new exemption amounts, you should not disregard filing a federal estate tax return. If the estate tax returns as expected in 2026, loss of portability due to failure to file an estate tax return could create a greater estate tax on the death of the survivor. For example, under current law, if you and your spouse have a gross estate over the exemption amount and do not use the full exemption during your lifetime, the surviving spouse (upon the first spouse’s death) can file a tax return electing to use the deceased spouse unused exemption.

You should not solely rely on the doubled exemption remaining permanent. For example, Husband passes in 2019 and has not used any of his estate tax exemption. If Wife does not file a federal estate tax return electing portability and dies in 2026 and the estate tax exemption has returned to the lower amount, she will have lost the ability to transfer over $5.5 million tax free. Filing for portability during the higher exemption period locks in the higher exemption amount if the estate tax returns to the current amount in 2026.

Non-Tax Estate Planning

Individuals might find themselves wanting a simpler estate plan that, for example, utilizes outright bequests rather than holding assets for children and grandchildren (for example) in trust.   However, trusts will still be important for many purposes such as dealing with children with special needs, assuring longevity of family wealth and for asset protection of the beneficiaries from outside creditors including, potentially, ex and future spouses.

Other Year End Considerations!

  • With most itemized deductions disappearing in 2018, a taxpayer should attempt to accelerate certain deductions in 2017.
  • In 2016, unreimbursed medical and dental expenses were deductible if they exceeded 10% of your adjusted gross income. Although the floor is lowered for unreimbursed medical and dental expenses to 7.5% in 2017 and 2018, taxpayers have to itemize their deductions in order for this lowered rate to benefit them. It is expected that most taxpayers will use the doubled standard deduction beginning in 2018. Therefore, if you do not anticipate itemizing your deductions next year, you should accelerate any medical or dental expenses into this year such as filling prescriptions, paying any outstanding bills, scheduling appointments and paying at the time of service, bills and if possible, accelerate any expenses that you have been postponing such as orthodontia, a hearing aid or laser eye surgery.
  • Because the state and local deduction will be limited to $10,000 starting in 2018, a taxpayer should pay off the outstanding balance of state and local income, property, or sales taxes in 2017 and prepay your 2018 real estate taxes before the new law takes effect.
  • Additionally, because the law states that you cannot deduct 2018 state and local income taxes that you prepay in 2017, you should pay all state and local taxes that you owe for 2017 by December 31 (even though your fourth quarter federal income tax estimated payment may not be due until January 16, 2018). If you wait to pay the state and local income taxes in 2018, you will not be able to deduct the expense on your 2017 tax return.
  • 2017 is the last year that you can take deductions on “miscellaneous expenses”. This deduction allows you to deduct certain expenses if they total more than two percent of your adjusted gross income. For employees, these expenses include union dues, uniforms, unreimbursed job travel and training. Additionally, fees associated with your investments such as those charged by accountants, financial advisers and lawyers are included as a miscellaneous expense. If you have any outstanding bills for investment expenses, you should pay them in 2017 in order to deduct the expenses on your 2017 tax return.
  • If you itemize your tax return and make charitable contributions, you should consider making your planned 2018 contributions in 2017 because you might lose the deduction if you wait until 2018 to make the contribution. If you take the standard deduction in 2018, you will not get any tax savings from your charitable contribution.
  • Due to the new individual income tax rates, a taxpayer will likely benefit from recognizing more income in 2018 (than 2017).

[1] This may not always be the case. There may be circumstances where the “combined QBI amount” calculated under the first test is less than “combined QBI amounts” calculated under the second or third tests. If that scenario arises, the “combined QBI amount” will be the amount calculated under the first test.

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