Tax Reform Now: Part 9

On November 16, 2017, the House of Representatives approved its version of the “Tax Cuts and Jobs Act” (the “Act”) by a vote of 227-205. All Democrats and 13 Republicans voted against the tax bill. Although potential obstacles still exist, Republicans are one step closer towards enacting comprehensive tax reform. The Senate Finance Committee is currently working on its tax reform bill. If the Senate passes this bill, a conference committee will be held to resolve the differences between the two versions. “Tax Reform Now” will highlight the significant changes included in the House’s tax bill for estates, individuals, pass-through businesses, and corporations.

Estates

The Act defangs the estate tax. Beginning in 2018, an unmarried individual’s estate, gift, and generation-skipping transfer tax exclusions will be doubled to almost $11 million. Thus, an unmarried individual can pass up to $11 million to his or her heirs without paying federal estate tax. A married couple can pass up to $22 million without paying federal estate tax. Furthermore, the House’s tax bill completely phases out the estate tax following the 2024 tax year.

Individuals

The Act seeks to streamline the individual income tax code and encourage more taxpayers to use the standard deduction. Under the Act, there will be four income tax brackets. These brackets will be 12%, 25%, 35%, and 39.6%. The alternative minimum tax will be repealed. The standard deduction will double to around $12,000 for unmarried individuals and $24,000 for married couples.

The Act eliminates nearly all itemized deductions. The status of some itemized deductions are worth mentioning. The charitable contribution deduction will be expanded under the Act. An individual will be able to take a deduction of up to 60% of the individual’s adjusted gross income for cash contributions to public charities or certain public foundations. Other itemized deductions will be eliminated or scaled back. For example, the alimony payment deduction will be repealed. As a result, an ex-spouse will not have to include alimony payments in gross income. This law will apply to any divorce or separation instrument executed after December 31, 2017. In the House, the status of the state and local tax deduction has been a divisive issue. The House’s tax bill allows an individual to deduct up to $10,000 of state and local property taxes. However, the deduction for state and local income taxes or sales taxes will be repealed. Many individuals currently take the home mortgage interest deduction. This deduction will be scaled back under the Act. The current home mortgage interest deduction rules will apply to all mortgages incurred on or before November 2, 2017. However, the home mortgage interest deduction rules will change for all mortgages incurred after that date. A married couple who purchases a home after November 2, 2017 will be entitled to take a maximum $500,000 home mortgage interest deduction. A married couple currently can take a $1 million home mortgage interest deduction on a principal residence and one other residence. Under the new rules, the home mortgage interest deduction can only be taken for mortgage interest paid on the individual’s principal residence.

The Act contains other interesting provisions. The Act changes the requirements that an individual must satisfy before he or she can exclude a portion of the gain from the sale of a principal residence from gross income. In order to exclude the gain, an individual must own and use the residence as a principal residence for five of the previous eight years. This exclusion can apply to one sale or exchange every five years. The Act restricts who can utilize this exclusion. A married couple with adjusted gross income greater than $500,000 will not be able to use this exclusion. Additionally, an individual will no longer be allowed to recharacterize a contribution to a traditional IRA as a contribution to a Roth IRA (or vice versa). Finally, the like-kind exchange rules will be altered. The gain or loss deferral on like-kind exchanges will only apply to like-kind exchanges of real property.

Pass-through Businesses

Under the Act, an individual owning a pass-through business will benefit if his or her pass-through business has net income above the 25% tax bracket threshold. When such a pass-through business distributes its net income to that individual, 30% of the distributed income will be treated as “business income” taxed at a maximum 25% rate. The remaining 70% of the distributed net income will be taxed at the individual’s personal income tax rate.

The amount of “business income” depends on whether the income derives from an active or passive business activity. The current material participation and activity rules will determine whether a business is considered an active or passive business activity. This distinction is important. All net income derived from a passive business activity will be treated as “business income.” For example, a limited partner is engaged in a passive business activity. Since passive investors are entitled to this preferential rate, individuals may be more inclined to be treated as passive investors.

The calculation of an individual’s “business income” derived from an active business activity is more complicated. First, an individual determines his or her net income derived from the active business activity. An individual’s wages would be included in net income. After calculating the net income, that individual determines the amount of “business income” eligible for the 25% rate. The amount of “business income” is 30% of the net income derived from the active business activity. The House refers to this 30% rate as a “capital percentage.” The resulting dollar amount is the amount of “business income” eligible for the preferential 25% rate. The remaining 70% of the net income passed through to the individual would be taxed at the individual’s income tax rate. An individual can choose to apply a different formula in order to get a “capital percentage” of greater than 30%. However, the facts and circumstances of the business will determine whether the individual can receive a larger rate. The election to use this formula will be binding for five years.

An individual working in a personal service business will have a capital percentage of 0%. A personal service business includes any business engaged in services related to law, accounting, consulting, engineering, financial services, or performing arts. As a result, an individual actively participating in a personal service business generally will not be eligible for the 25% rate on “business income.” That individual will continue to be taxed at their own individual income tax rate.

Corporations

Corporations are the biggest beneficiaries under the Act. The corporate tax rate will be lowered from 35% to a flat 20% rate starting in 2018. This rate reduction is the biggest one-time drop in the maximum corporate tax rate in United States history. To encourage more investment in businesses, the Act will allow businesses to immediately deduct the entire cost of investment in “qualified property” acquired and placed in service after September 27, 2017. This immediate deduction will be available for five years. However, “qualified property” does not include any property used in a real property trade or business. Like the House’s treatment of most deductions, a corporation’s dividend received deduction will be scaled back. 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.

We hope this update has been helpful. As always, please let us know if you have any questions.