Following the 8-week period ends from the date a PPP loan is disbursed, a borrower must actually petition the SBA for forgiveness of the loan. The SBA has just published the PPP Forgiveness Application and Template. You can also visit sba.gov for additional Small Business Guidance & Loan Resources.
The CARES Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from an eligible retirement plan (e.g., 401(a), 401(k), 403(b), and 457 plans), and IRAs to qualified individuals, as well as special rollover rules with respect to such distributions.
A coronavirus-related distribution is a distribution from an eligible retirement plan or IRA to a qualified individual from January 1, 2020 to December 30, 2020, up to an aggregate limit of $100,000 from all plans and IRAs.
A qualified individual is someone who has (i) a coronavirus-related diagnosis based on a CDC-approved test, (ii) a spouse or dependent with such a diagnosis, or (iii) experienced certain coronavirus-related adverse financial consequences.
The CARES Act also increases the limit on the amount a qualified individual may borrow from an eligible retirement plan (not including an IRA) and permits a plan sponsor to provide qualified individuals up to an additional year to repay their plan loans.
Waiver of 10% early distribution penalty. The additional 10% tax on early distributions from such plans and IRAs is waived for coronavirus-related distributions, which may, subject to guidelines, be re-contributed to the plan or IRA.
Deferral of Income Tax on Coronaviraus-Related Distributions. Income arising from coronavirus-related distributions is spread out over three years unless the recipient elects to turn down the spread out.
Waiver of Required Distribution. Required minimum distributions (RMD) that otherwise would have to be made in 2020 from defined contribution plans (such as 401(k) plans) and IRAs are waived. This includes distributions that would have been required by April 1, 2020, due to the account owner’s having turned age 70½ in 2019. While the CARES Act does not specifically address inherited IRAs, beneficiaries of inherited IRAs from account owners who died before January 1, 2020 should not have to take an RMD in 2020. For beneficiaries of inherited IRAs from account owners who died after December 31, 2019, the 10-year period for non-eligible designated beneficiaries of inherited IRAs from account owners does not begin until 2021. For non-designated beneficiaries of inherited IRAs who are receiving distributions over a 5-year period, like estates and charities, 2020 will not count as one of the five years.
Note: Roth IRAs do not require minimum distributions during the account owner’s lifetime.
Increased Limits on Nontaxable Loans. Limits on nontaxable loans from qualified employer plans, to a qualified individual during the 180-day period beginning on Mar. 27, 2020, and ending Sept. 22, 2020, are increased from $50,000 to $100,000, and the benefit percentage limit is increased from 50% to 100% of the present value of the employee’s nonforfeitable accrued benefit.
Delayed Due Date for Qualified Plan Loans. If a qualified individual has an outstanding plan loan from a qualified employer plan, any repayment of the loan that is due during the period beginning Mar. 27, 2020, and ending on Dec. 31, 2020, “shall be delayed for 1 year”. Any later loan repayments must be adjusted to reflect the delay in the due date and any interest accruing during the delay. In determining the five-year term limit and level amortization requirement for such loans, the one-year period described above must be disregarded.
An employer is permitted to choose whether, and to what extent, to amend its plan to provide for COVID-19-related distributions and/or loans that satisfy the provisions of section 2202 of the CARES Act. Thus, e.g., an employer may choose to provide for COVID-19-related distributions but choose not to change its plan loan provisions or loan repayment schedules. Even if an employer does not treat a distribution as COVID-19-related, a qualified individual may treat a distribution that meets the requirements to be a COVID-19-related distribution as COVID-19-related on the individual’s federal income tax return. The IRS has announced that the rules adopted to implement the retirement plan relief provisions enacted following Hurricane Katrina—KETRA—will be followed in implement the retirement plan relief provisions of the CARES Act.
A few weeks ago, we wrote about how the dramatic reduction in interest rates presented planning opportunities. Each month, the IRS announces the minimum interest rate required to be charged for loans in order to avoid a gift (known as the applicable federal rate). This rate is determined based upon Treasury Bill rates. As we wrote, the April 2020 applicable federal rates had fallen to rates not seen for many years.
Incredibly, the IRS has announced that the May and June 2020 rates are even lower than the April 2020 rates. For example, the May 2020 rate for loans of three years or less is only 0.25% and for loans of more than three years but not more than nine years is only 0.58%. Moreover, the June 2020 rate will be only 0.18% and 0.43%, respectively (The corresponding rates in March 2020 were 1.50% and 1.53%, respectively, and in April 2020 were 0.91% and 0.99%, respectively.)
Thus, May and June 2020 are an ideal time to consider the following techniques in order to transfer wealth to younger generations:
A grantor may sell assets to a trust in exchange for a promissory note. (As a rule of thumb, the trust should have assets equal to at least 10% of the value of the assets sold.) Typically, the promissory note provides for interest with the principal payable at the end of the loan term. Thus, the assets need to merely grow at a rate in excess of the applicable federal rate. Further, the grantor may allocate GST exemption to the assets transferred to the trust so that the trust may be a dynasty trust continuing on for generations transfer-tax free.
Moreover, the trust may be designed as a “grantor trust” so that the trust is treated the same as the grantor for federal income tax purposes. Thus, the grantor is taxed on all of the income and gains and transactions between the grantor and the trust do not cause gain recognition. Effectively, when the grantor pays the income tax on the trust’s income and gains, the grantor is making a “tax-free” gift to the trust, thereby increasing the potential to transfer wealth.
A grantor retained annuity trust or GRAT is a technique that allows the grantor to transfer substantial value to a trust with little (or no) immediate gift tax consequences by retaining the irrevocable right to receive a fixed annuity amount payable for a term of years (the “Annuity Payment”). The estate tax benefit of the GRAT is that any appreciation above the “Section 7520 Rate” on the assets transferred to the GRAT, passes to the remainder beneficiaries free of additional gift or estate taxes. The Section 7520 rate is calculated based upon 120% of the applicable federal rate for a nine-year loan discussed above. For May 2020, the Section 7520 rate is a mere 0.8% and for June is an even lower 0.6%. This means that, in order for the GRAT technique to be successful for a GRAT created in June, the earnings on the GRAT assets must only exceed 0.6%. This is the lowest Section 7520 rate in history.
The GRAT technique is particularly attractive when the value of assets has been depressed, assuming that there is an expectation of appreciation. Thus, the significant drop in stock prices over the last two months and the effect of current market conditions in valuing non-controlling interests in business entities, including family limited partnerships, may present opportunities to pass significant wealth. (Moreover, if the IRS were ever to successfully challenge the value of a business interest, the GRAT automatically adjusts the annuity amount without any adverse gift tax consequences.) Finally, even if the GRAT technique fails because the assets do not appreciate in value, the grantor will receive back all of the assets in satisfaction of the annuity payments without significant gift tax consequences.
Under the CARES Act, several types of loans were made available to business owners. The loan program which has generated the greatest discussion (and controversy) is known as the Paycheck Protection Program (“PPP”). The PPP loan was designed to aid businesses which might be imperiled by the Covid-19 Coronavirus. With massive unemployment looming (and in fact now at nearly 15%), the PPP program provided eligible employers with “forgivable” loans to be used primarily for employee salaries (not to exceed $100,000 on an annualized basis) to both keep businesses running and try to offset the impending overwhelming claimants filing for unemployment benefits. Generally speaking, a business could obtain a loan equal to 2.5 times its average monthly payroll. The loan would be forgiven in its entirety if during the 8 week period beginning on the date that the loan proceeds were actually received, if at least 75% of the loan proceeds were used on compensation (again, capped at $15,384 for that 8 week period for any employee) and the remaining funds were used (generally) for qualified mortgage payments, rent and utilities (see more detailed discussion at the end of this article). To the extent that the loan proceeds were not used in accordance with the preceding sentence, the loan would have to be repaid. If the loan was forgiven, there would be no taxable event to the borrower, and it appears, that most likely, the business would also get the deduction for its rent, utilities and compensation paid with the borrowed PPP funds.
Under the CARES act, in order to receive a PPP loan, borrowers had to make several certifications to the banks, including “that the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient” (the “Certification”). At first blush, this certification seemed simple since the uncertainty regarding the Pandemic caused almost every employer to consider massive reductions in staff and compensation; in fact, many employers have participated in massive payroll cuts, layoffs, furloughs and terminations. However, because a number of major corporations applied (and received the PPP loan) despite having adequate access to major capital reserves and other funds, like almost everything, passionate reactions ensued. Several senators wanted to equate the Certification to the ability to obtain any other funds whether through loan, capital reserve, etc., while others wanted to test the Certification against actual revenue. Obviously, neither of these approaches made sense because Borrowers generally had no knowledge of how their business would prospectively perform or whether there would be any ability, or whether it even would be wise, to try to further leverage their imperiled business. And, of course, many would argue that the PPP was really made available, in large part, to assist small business owners from having to lay off employees and to keep as many employees off the unemployment rolls as possible.
The SBA has put out a series of Frequently Asked Questions (FAQ) on its’ website. FAQs 31 and 37 caused incredible controversy when it became clear that a failure to meet the Certification requirements (whatever they might ultimately be) could cause the business owner to be fined up to $1,000,000 and spend up to 30 years in prison! In fact, the SBA provided amnesty to business owners to return their PPP funds by May 7, 2020, if they felt they could not meet the undefined and wildly debatable Certification requirement. The May 7 deadline was later extended to May 14 with a promise that the SBA would provide further guidance before May 14th.
On May 13, the SBA added FAQ 46 to directly address the panic that was besieging PPP borrowers. FAQ 46 clarifies that “any borrower that, together with affiliates, received PPP loans with an original principal amount of less than $2 million will be deemed to have made the required certification concerning the necessity of the loan request in good faith”. The SBA states that borrowers of less than $2 million are less likely to have had access to adequate sources of liquidity than larger borrowers, and given the large number of PPP loans would allow the SBA to be more thorough, given its limited audit resources to concentrate on borrowers with loans greater than $2 million.
For most borrowers, FAQ 46 is a huge relief. However, it is important to remember that if you are PPP borrower that you will still have apply for forgiveness of your PPP Loan. Your bank will review your forgiveness application (and same will be subject to SBA review) to confirm that your PPP loan was used for payroll (at least 75% of your PPP proceeds), costs related to the continuation of group health care benefits during periods of paid sick, medical, or family leave, and insurance premiums; mortgage interest payments (but not for mortgage prepayments or principal payments); rent payments, utility payments, interest payments on any other debt obligations incurred before February 15, 2020; and refinancing as SBA Economic Injury Disaster Loan made between January 31, 2020 and April 3, 2020 (with some specific rules relating to same).
If you should have any questions regarding the PPP program, please give us a call.
Our attorneys have been actively working to complete existing estate planning projects, but we are also available to take on new estate planning matters. In addition to those who have contacted our office because of concerns that the COVID-19 coronavirus raises, our attorneys have been contacted by clients who want to make changes in their estate plans because of the significant downturn in financial markets. These clients are worried that because of the drop in their net worth, their existing estate plans no longer accomplish their goals. For example, clients seeking to reduce or eliminate specific bequests to ensure that their children receive a sufficient benefit from their estate plan, or to adjust formula gifts to ensure that their spouses receive a sufficient benefit from their estate plan.
Estate Planning Opportunities
Further, the combination of the downturn in financial markets and the dramatic reduction in interest rates present planning opportunities. For 2020, the unified federal estate, gift and generation-skipping transfer tax exemption is $11.58 million, an increase of $180,000 from 2019.
— The minimum interest rate required to be charged for loans in order to avoid a gift (known as the applicable federal rate) has fallen to rates not seen for many years. For example, the April 2020 rate for loans of three years or less is only 0.91% and for loans of more than three years but not more than nine years is incredibly only 0.99%. (The corresponding rates in March 2020 were 1.50% and 1.53%, respectively.) Thus, April 2020 is an ideal time to make loans to family members or trusts for their benefit or to refinance existing loans that have higher interest rates.
— A grantor retained annuity trust or GRAT is a technique that allows the grantor to transfer substantial value to a trust with little (or no) immediate gift tax consequences by retaining the irrevocable right to receive a fixed amount payable at least annually for a term of years (the “Annuity Payment” or “Retained Interest”). The estate tax benefit of the GRAT is that any appreciation above the “Section 7520 Rate” on the assets transferred to the GRAT, passes to the remainder beneficiaries free of additional gift or estate taxes. The Section 7520 rate for April 2020 is merely 1.2%, meaning that, in order for the GRAT technique to be successful, the earnings on the GRAT assets must only exceed 1.2%.
The unyielding impact of the Coronavirus pandemic cannot be understated, especially considering the ever-increasing invocation of “force majeure” clauses in connection with contracts entered into before this disease took the world by storm. While there are no clear answers, we hope to guide you into asking questions that we are happy to discuss with you, and of possible recourse in these trying times.
You have likely seen a provision concerning a force majeure event in contracts, such as your lease. Generally speaking, force majeure is an unforeseeable circumstance that prevents someone from fulfilling a contract.
So does force majeure cover the Coronavirus? The answer is, as expected, that it depends. First and foremost, the terms of the contract always prevail, and courts typically construe force majeure clauses very narrowly. Even if the result is ostensibly unforgiving or imbalanced, a court is bound by the law to interpret a contract according to its plain and unambiguous meaning. Further, the party seeking to assert the force majeure clause typically has the burden of proving its applicability, including that the event was beyond its’ control and without its’ fault or negligence. So arguably, if your contract has a force majeure clause, but does not contain language that would cover an epidemic/pandemic/disease, or something along those lines, then the clause may not apply. If the clause does contain language that could be perceived as covering an epidemic/pandemic/disease, that does not automatically mean that your obligations cease.Your remedy largely depends on what the contract permits.
What if your force majeure clause includes the general “Act[s] of God”? An Act of God that will excuse the nonperformance of a contract must be an act or occurrence so extraordinary and unprecedented that human foresight could not anticipate or guard against it, and the effect of which could not be prevented or avoided by the exercise of reasonable prudence, diligence, and care. There must be no admixture of negligence or want of diligence, judgment, or skill on the part of the promisor (i.e., the person who made the promise). Whether Coronavirus falls within the definition of an Act of God is open to interpretation, but it would not necessarily be unreasonable to argue such a position.
It should be noted that taking precautionary measures or making a voluntary decision not to perform is not the same as being prevented from performance. An unexpected impediment to the performance of a contract will not relieve a party from contractual obligations, unless the party’s performance is rendered impossible by an Act of God. Choosing to close a business down as a preventative measure does not necessarily trigger the Act of God provision.
Ultimately, whether Coronavirus falls within force majeure is a fact-intensive inquiry that depends on your actions, the contract, and outside forces, among other things.
What If Your Contract Does Not Contain A Force Majeure Clause?
Florida law has “gap-fillers” such as impossibility/impracticability and/or frustration of purpose if a contract has no force majeure clause. The applicability of frustration and/or impossibility is a fact intensive inquiry, and the courts are narrow in their application of such positions, as courts are reluctant to excuse performance that is not impossible but merely inconvenient, profitless, and expensive.
For frustration, the parties must consider whether the purpose underlying the agreement has been frustrated for both parties. Specifically, where performance is possible but an alleged frustration, which was not foreseeable, totally or nearly totally destroyed the purpose of the agreement. Some examples cited in a Florida case where frustration did not apply, include:
– Lessee’s obligation continues where risk of war and consequent limitation made business unprofitable but not impossible;
– Lessee must continue to pay rent where object of contract, use of grain elevator, possible but tariff rise, anticipated when lease renewed, made use unprofitable;
– Doctrine of economic frustration and doctrine of impossibility unavailable to void lessee’s purchase contract where zoning change modified but did not negate proposed use of property under lease).
In sum, just because Coronavirus renders running the business costly or unprofitable, does not mean that you are relieved from paying your rent or other obligations. The rationale is that you are still able to rent the property, you are just not able to make money from occupying it.
For impossibility, the parties must evaluate whether performance is objectively impossible (i.e., will performance merely be difficult or expensive, or can a party genuinely not perform its’ contractual obligations). In applying the preceding, there may be a valid impossibility defense if, for example, a person necessary to performance has died or become incapacitated or quarantined, or if performance has been rendered illegal by government containment procedures or other regulations.
Recently, the New York legislature vested the state’s executive branch with unilateral power to change or suspend state law so long as it is done in furtherance of New York’s response to the Covid-19 coronavirus. See, Section 29-a of Article 2-B of the Executive Law. For example, Governor Andrew Cuomo has ordered school closings, the shuttering of non-essential businesses, and shelter-in-place restrictions.
Effective March 20, 2020, Governor Cuomo ordered the suspension of any specific time limit to file or commence any legal action, motion, notice or other proceeding through April 19, 2020. This Executive Order applies to all proceedings: probate, civil, criminal, and family. New York’s Commissioner of Taxation and Finance is now vested with the authority to abate late filing and payment penalties for a period of 60 days for taxpayers who are required to file returns and remit sales and use taxes for the sales tax quarterly period that ended February 29, 2020. In addition—for a period of 90 days—commercial and residential landlords cannot enforce evictions, and foreclosures shall cease.
To be sure, the tolling of the statute of limitations occurs routinely in certain situations, for example, when a party is a minor or discovery of the civil wrong is not learned of until later (e.g., the doctor left a sponge in the patient). By suspending the statute of limitations, in all situations, New York has effectively tolled all litigation in the state. The proverbial clock has stopped running. For our practice area in New York, this Executive Order indefinitely extends statutory deadlines to foreclose an individual’s rights in a probate or trust administration or litigation, and, impairs existing contractual obligations (e.g., lease agreements that are presently being breached). Time will tell what the socioeconomic cost and effect will be of this Executive Order.
At this time, there is no parallel order in Florida. It remains to be seen whether Florida will follow New York’s leading in enacting a suspension of the statute of limitations and other analogous relief as part of its response to the Covid-19 coronavirus.
With the Coronavirus pandemic causing widespread disruption, the IRS has given taxpayers one less thing to worry about. On March 20, the IRS issued Notice 2020-18, which automatically postpones until July 15 the due date for filing a Federal income tax return and paying Federal income tax.
Here’s what you need to know:
– The due date for filing Federal income tax returns and making Federal income tax payments due on April 15, 2020, has been postponed until July 15, 2020.
– The relief is automatic. Taxpayers do not need to file an extension request.
– The postponement applies to individuals, trusts, estates, partnerships, associations, companies, and corporations.
Keep in mind, the postponement only applies to Federal income tax, so deadlines for other Federal taxes and returns (such as gift tax and information returns), remain unchanged. Notice 2020-18 supersedes Notice 2020-17, which only deferred the due date for payments based on dollar limitations and, importantly, did not defer the filing deadline.
Physician employers (“Medical Practices”) often ask physicians to sign non-competition agreements in order to protect the Medical Practice’s legitimate business interests, such as confidential information, existing patient relationships, specialized training, or professional goodwill. In Florida, a non-competition agreement is generally upheld if the non-competition covenants are reasonable in time, geographic area, and line of business. Under Florida law, a party often must prove that a non-competition agreement violates public policy in order to invalidate a non-competition agreement. In June, Florida passed a law that, in counties where all of the medical providers of a given specialty are employed by the same entity, vitiates the enforceability of non-competition agreements. Thus, a Medical Practice employing physicians who provide services in a medical specialty at a monopolistic level in a given Florida county should be aware that their non-competition agreements may no longer be valid. With the enactment of this new law, a physician covered by this new law may practice in a county which was deemed to be a prohibited geographic area in the non-competition agreement without having to prove that such non-competition agreement violated public policy. The number of physicians and Medical Practices affected by this new law is currently unknown. However, the United States District Court for the Northern District of Florida recently issued a ruling analyzing this new law, and the court’s decision should be of particular interest to Medical Practices operating at a monopolistic or near-monopolistic level in a given Florida county and physicians employed by such Medical Practices.
Until the recent passage of a new law, Florida physicians signing non-competition agreements were subject to the general rules regarding non-competition agreements. For example, a physician might sign a non-competition agreement which restricts the physician from practicing in geographic areas where the Medical Practice does business. However, Florida Statutes § 542.336 disrupts the status quo for non-competition agreements entered into between certain physicians and Medical Practices. Florida Statutes § 542.336 declares that all non-competition agreements entered into between physicians practicing a “medical specialty” in a county where one entity employs or contracts with all physicians who practice such specialty in such county are void and unenforceable because such non-competition agreements are not supported by a legitimate business interest. The restrictive covenants contained in such non-competition agreement remain void and unenforceable until three years after the date on which a second entity that employs or contracts with one or more physicians who practice that specialty begins serving patients in that county. The professed public purpose of this new law was to reduce healthcare costs and improve patient access to physicians. This new law took effect on July 1, 2019. However, the new law does not specifically address whether this law applies retroactively to contracts already in effect on July 1, 2019, or prospectively to contracts entered into on or after July 1, 2019. Despite this uncertainty, physicians subject to non-competition agreements have begun to practice their medical specialty in a geographic area prohibited by the terms of their respective non-competition agreements. As expected, Medical Practices have called into question the validity of this new law.
In 21st Century Oncology, Inc. v. Moody, Case No.: 4:19cv298-MW/CAS; 2019 WL 3948099 (N.D. Fla. Aug. 21, 2019), a Medical Practice that employs a variety of physicians in several Florida counties, sought to enjoin the enforcement of Florida Statutes § 542.336 on the basis that this law violated the Contracts Clause, Due Process Clause, and Equal Protection Clause of the United States Constitution. The Medical Practice in this case employed all nine radiation oncologists practicing in Lee County, Florida. The nine radiation oncologists were parties to non-competition agreements with the Medical Practice. Within the past year, five of those oncologists severed their relationships with the Medical Practice. Following the passage of Florida Statutes § 542.336, some of those oncologists began to practice radiation oncology in Lee County, presumably in contravention of the geographic restrictions imposed in their non-competition agreements.
Judge Walker of the United States District Court for the Northern District of Florida denied the Medical Practice’s motion for a preliminary injunction because the Medical Practice was unable to make the requisite showing as to any of its claims. Although the passage of Florida Statutes § 542.336 was a significant impairment on the Medical Practice’s employment contracts with the physicians, the court determined that the degree of this impairment did not outweigh the significant public purpose of providing access to affordable healthcare. Furthermore, the court found that the regulation of physician non-competition agreements on the basis of the county where services are provided was a reasonable choice. The court stated that it was feasible that the Florida legislature passed this law out of a concern for the ongoing trend of consolidating physician services and how such consolidation affects access, costs, and consumer choice. Thus, the court found that the Florida legislature rendering certain non-competition agreements void was an acceptable response to these concerns. As a result, the court denied the Medical Practice’s motion for a preliminary injunction.
Florida Statutes § 542.336 adds another wrinkle to the relationship between Medical Practices and physicians. At this point, more research is needed to determine how many Medical Practices and physicians will be affected by Florida Statutes § 542.336. The new law does not specifically address whether it applies retroactively to non-competition agreements already in effect on July 1, 2019, or prospectively to non-competition agreements entered into on or after July 1, 2019. However, the physicians in 21st Century Oncology, Inc. likely signed their non-competition agreements prior to July 1, 2019. Thus, Medical Practices and physicians should understand that this new law may apply retroactively to existing non-competition agreements. As noted in the court’s opinion, the consolidation of physician services is a nationwide trend arguing that this new law could improve patient access to physicians.
On June 21, 2019, the United States Supreme Court held that a North Carolina statute, which imposed a tax on a trust based solely on the residency of the beneficiary, violated the Due Process Clause of the United States Constitution. In the case, North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, Case No. 18-457 (S. Ct. June 21, 2019), a New York resident created a trust for the benefit of his children and appointed a fellow New York resident as trustee. The trust gave the trustee absolute discretion to distribute the trust’s income and assets to the beneficiaries. At the time the trust was created, none of the beneficiaries lived in North Carolina; however, the trust was later divided into separate subtrusts for each child, one of whom resided in North Carolina and her minor children. Although the child and her children were beneficiaries of the trust, the trust did not actually distribute any income or principal to those beneficiaries. Thus, the trust’s only connection with North Carolina was the mere presence of its beneficiaries within the state. The now unconstitutional North Carolina statute imposed taxes on any trust income that is for the benefit of a North Carolina resident. Accordingly, the North Carolina Department of Revenue assessed a tax on all of the income of the trust, which the trustee was required to pay. The trustee then sued North Carolina for a refund, alleging that the tax was unconstitutional.
In order for a state tax to pass muster under the Due Process Clause of the Constitution, there must be a “minimum connection” between the state and the person or property it seeks to tax (Quill v. North Dakota, 504 U.S. 298 (1992), overruled on other grounds, South Dakota v. Wayfair, Inc., 585 U.S.____ (2018)). The Court ruled that the residency of a beneficiary within the taxing state alone is insufficient to establish the minimum connection required under the Constitution. Notably, the Court limited its ruling to circumstances where the trust’s income is not distributed to the resident-beneficiary and such resident-beneficiary has no right to demand the distribution of the trust income, or be entitled to receive the trust income in the future.
The most immediate significance of this decision is for trustees of trusts with beneficiaries residing in North Carolina or Tennessee, which has a similar taxing statute. Trustees who have been paying income tax to those states with respect to the trust’s undistributed income or capital gains should review those trusts immediately to determine if those taxes can be are recovered by a claim for refund.
The broader application of this decision isn’t clear. The narrow scope of the Court’s analysis, as noted specifically in the decision, leaves unanswered the question of what additional connections may be sufficient to create a link between a state and the trust that supports state taxation.
We are excited to announce that after spending 19 years in the Financial Center at the Gardens, the firm has officially signed a new lease with DiVosta Towers at 3825 PGA Boulevard, with a set move in date of November 1, 2019.
From the inception of the firm by founding partners, Richard B. Comiter and Michael S. Singer, the intention was always to remain a small boutique office, never exceeding more then 8 employees, including staff. However, since the inception of CSBB in 2000, the firm has grown by 400%– with a total of 32 employees, including 5 partners and 5 associates (with more to come).
After quietly opening a second office in Boca (1951 N.W. 19th Street), Comiter, Singer, Baseman & Braun, LLP will be taking over the entire 7th floor, as well as 1/4th of the 1st floor in the Southern Tower of DiVosta Towers at 3825 PGA Blvd.
“We are excited about moving into Divosta Towers, the premier property in Downtown Palm Beach Gardens which will be the signature of the North County skyline,” says Managing Partner, Michael S. Singer. “The office gives us the opportunity to be in a brand new, state of the art facility as our practice continues to grow.”
Each year if you have a Florida Business Entity such as a Corporation, Limited Liability Company, Partnership or Foundation, the State requires that you pay a renewal fee in varying amounts. For many of you we provide this service at a nominal cost. Others renew their entities directly online.
In the coming weeks you will see numerous correspondence purporting to be from agencies that appear to be “official”. These agencies will instruct you that you have to complete your annual report (through them) and also tell you that you need a certificate of status. These entities are not agencies of the State and these items you get in the mail are all solicitations. You may go online directly to renew your entity at sunbiz.org or if we provide this service, we will do so for you. If you are going to file the report directly, please let us know immediately (by February 10, 2019) or we will assume that we will continue to file for your entity if we have done so in the past. In any event, please disregard the notices you receive in the mail from so called “State of Florida Agencies” and other agencies, looking to do your annual report, or sell you a certificate of status. The fees that they are charging are substantially higher than the state and there is no guarantee that your work will actually get done.
‘Tis the season of giving, and even the Internal Revenue Service is feeling generous, with proposed regulations that would allow taxpayers to take advantage of the increased exemption amount for estate and gift taxes without fear of retroactive taxation.
The federal transfer taxation system is based on the fair market value of property transferred, either during lifetime or at death, to others. Two components of this system, the gift tax and the estate tax, are part of a unified method of transfer taxation whereby the aggregate value of both lifetime and testamentary gifts is subject to a single tax. Prior to 2018, a “unified exemption” amount permitted an individual to make taxable transfers by gift during life or at death to the extent of $5,000,000 (as indexed for inflation) in value without having to pay the gift and/or estate tax on such transfers.
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the “TCJA”), which increases the unified estate and gift tax exemption amount to $10,000,000 per person ($11,180,000 in 2018 and $11,400,000 in 2019, as indexed for inflation). However, this increase is currently set to expire at year-end of 2025, when the exemption amount will drop back to the pre-TCJA amount. This looming expiration date caused significant concern among estate planning professionals, who were hesitant to advise clients to make gifts above the pre-TCJA exemption amount for fear that the IRS would retroactively tax such gifts.
In response to these concerns, the Internal Revenue Service issued proposed regulations which state that there will be no clawback of the increased exemption amount used prior to 2026. So, for example, if an unmarried taxpayer makes a $7 million gift in 2024 and dies in 2027 (after the exemption has returned to $5 million), there will be no tax due on the extra $2 million gift.
Clients with estimated estates above the pre-TCJA exemption amount, and the estate planning professionals advising them, are likely to take a “wait-and-see” approach – meaning they will wait until it is certain, from Congressional action or inaction, that the increase in the exemption amount will in fact sunset. As such, assuming complete legislative silence on the matter, it is expected that the bulk of the gifts benefitting from the anti-clawback regulations would take place during 2025, when the expiration of the increased exemption amount would be inevitable.
However, taxpayers should feel fairly confident that any gifts made between now and 2025 will be safe from any clawback.
The IRS will hold a hearing on the proposed regulations on March 13, 2019.
The Opportunity Zone program presents a unique opportunity for a taxpayer to defer the capital gains tax by investing the proceeds of a realized capital gain in a Qualified Opportunity Fund (“Opportunity Fund”) holding certain property in a Qualified Opportunity Zone (“Opportunity Zone”). The goal of the Opportunity Zone program is to encourage economic growth and investment in Opportunity Zones. Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code discuss Opportunity Zones. On October 19, 2018, the Treasury Department and the Internal Revenue Service (“IRS”) issued proposed regulations under Section 1400Z-2 (the “Proposed Regulations”). Although the Proposed Regulations are not yet finalized, the Proposed Regulations provide guidance for issues that were unresolved in the text of Section 1400Z-2. In addition to these Proposed Regulations, the Treasury Department and the IRS expect to publish additional proposed regulations in the near future.
I. Realized and Recognized Gains
When property is sold or exchanged, a taxpayer can realize a gain or loss. The realized gain or loss from a sale or exchange of property is usually a recognized gain or loss for tax purposes. A recognized gain must be included in gross income. A taxpayer then pays taxes on the recognized gain. However, a taxpayer is not always required to recognize a gain in the same year that the gain is realized. Under the Opportunity Zone program, a taxpayer who realizes a capital gain on the sale or exchange of a capital asset can defer the gain recognition event by investing the proceeds of the realized capital gain in an Opportunity Fund.
II. Review of Opportunity Zone Program and Tax Consequences
As a refresher, an Opportunity Zone is a nominated population census tract that is considered a low-income community. In Florida, then-Governor Rick Scott designated 427 communities as Opportunity Zones, including 26 communities in Palm Beach County. A taxpayer invests in an Opportunity Zone by purchasing an interest in an Opportunity Fund. An Opportunity Fund is a corporation or a partnership that holds at least 90% of its assets in qualified opportunity zone property. Qualified opportunity zone property includes qualified opportunity zone business property, qualified opportunity zone stock, and a qualified opportunity zone partnership interest. For a more detailed discussion of Opportunity Zones and Opportunity Funds, please review our prior post entitled “New Tax Deferral Possibility by Investing in Qualified Opportunity Zone.”
If a taxpayer realizes a capital gain on the sale or exchange of any capital asset to an unrelated person, the taxpayer can defer the gain recognition event by investing the proceeds in an Opportunity Fund. However, the taxpayer must recognize this realized capital gain at the earlier of (i) the date on which the taxpayer sold or exchanged the Opportunity Fund interest, or (ii) December 31, 2026. Except as provided below, the taxpayer’s basis in an Opportunity Fund interest will be zero. A taxpayer can increase their basis by holding the Opportunity Fund interest for at least five years. If a taxpayer holds the Opportunity Fund interest for five years, the taxpayer’s basis in the Opportunity Fund interest increases from zero to 10% of the deferred capital gain invested in the Opportunity Fund. If a taxpayer holds the Opportunity Fund interest for seven years, the taxpayer’s basis in the Opportunity Fund interest increases to 15% of the deferred capital gain invested in the Opportunity Fund. If a taxpayer holds the Opportunity Fund interest for ten years and sells the interest after December 31, 2026, such taxpayer’s basis in the Opportunity Fund interest will equal the fair market value of the Opportunity Fund interest on the date that such interest is sold or exchanged. In such an instance, a taxpayer will only pay taxes on the original deferred capital gain.
III. Eligible Types of Gains for Opportunity Zone Program
The wording of Section 1400Z-2(a)(1) made it unclear whether Congress intended for capital gains and ordinary gains to be eligible for the tax deferral benefit under Section 1400Z-2. The Proposed Regulations clarify that only capital gains are eligible for the tax deferral benefit. Under the Opportunity Zone program, a taxpayer may defer the capital gains tax by rolling over the proceeds of a realized capital gain into an Opportunity Fund. A taxpayer can defer the amount of capital gain eligible for the capital gains tax up to the amount of the capital gain proceeds invested in an Opportunity Fund. Regardless of when a taxpayer recognizes the deferred capital gain, the deferred capital gain retains the same tax attributes in the year of inclusion that it would have had if the tax on the capital gain had not been deferred.
IV. Eligible Taxpayers for Opportunity Zone Program
Section 1400Z-2 did not adequately describe what types of taxpayers were eligible to invest in Opportunity Funds. For instance, it was unclear whether a partner or shareholder in a partnership or S corporation could invest in an Opportunity Fund when the partnership or S corporation was the taxpayer that sold a capital asset and generated a capital gain. The Proposed Regulations clarify that taxpayers eligible to invest in an Opportunity Fund include individuals, C corporations, partnerships, S corporations, trusts, and estates. The Proposed Regulations provide special rules for applying Section 1400Z-2 to a partnership, S corporation, trust, or estate. Under the special rules, either a partnership or its partners can take advantage of the tax benefits afforded by the Opportunity Zone program. If a partnership generates the capital gain, the partnership must have the first opportunity to make an election to defer the capital gain by investing in an Opportunity Fund. If the partnership makes this election, the deferred capital gain is not included in the distributive shares of the partners under Section 702 and is not subject to Section 705(a)(1) until the partnership subsequently includes such capital gain in income. If a partnership declines to invest the capital gain in an Opportunity Fund, the individual partners can defer the capital gains tax by investing the capital gain allocated to such partner in an Opportunity Fund. The aforementioned special rules also apply to an S corporation and its shareholders, a trust and its beneficiaries, or an estate and its beneficiaries.
In order to elect to defer the capital gains tax, Section 1400Z-2(a)(1)(A) provides that a taxpayer must invest the capital gain proceeds in an Opportunity Fund within 180 days from the date of the sale or exchange of the capital asset. The Proposed Regulations relax this requirement when a partnership generates the capital gain, elects not to invest in an Opportunity Fund, and then distributes the capital gain to its partners. If, following the distribution of the capital gain proceeds to the partners, a partner elects to invest any portion of the capital gain proceeds in an Opportunity Fund, the Proposed Regulations provide that such individual partner’s 180 day period to invest the capital gain proceeds begins on the last day of the partnership’s tax year.
V. Structure of Opportunity Funds
The Proposed Regulations describe the form in which an Opportunity Fund can be structured. An Opportunity Fund can be any entity classified as a corporation or partnership for federal income tax purposes. Thus, an Opportunity Fund can be structured as a limited liability company. A pre-existing entity may become an Opportunity Fund, but such entity must satisfy all of the requirements of Section 1400Z-2 and the Proposed Regulations. For example, a pre-existing entity must acquire a sufficient percentage of qualified opportunity zone property after December 31, 2017. The Proposed Regulations provide rules describing how an entity can self-certify as an Opportunity Fund without IRS approval. To self-certify as an Opportunity Fund, the corporation or partnership must complete a form and attach it to a timely filed federal income tax return. Simultaneously with the release of the Proposed Regulations, the IRS promulgated Form 8996, which is an early release draft of the self-certification form.
The Proposed Regulations discuss the interests that can be issued by an Opportunity Fund. For purposes of Section 1400Z-2, an eligible interest in an Opportunity Fund includes any equity interest issued by the Opportunity Fund. An equity interest includes preferred stock or a partnership interest with special allocations. However, an eligible interest does not include any debt instrument within the meaning of Section 1275(a)(1) and Treas. Reg. Section 1.1275-1(d). Interestingly, the Proposed Regulations provide that a taxpayer who owns an Opportunity Fund interest can use such interest as collateral for a loan, as long as such taxpayer is the owner of the equity interest for federal income tax purposes.
VI. 90% Asset and Substantial Improvement Requirements
Under Section 1400Z-2(d)(1), an Opportunity Fund must hold at least 90% of its assets in qualified opportunity zone property (“QOZ Property”) located in an Opportunity Zone. This 90% asset test is determined by averaging the percentage of QOZ Property held in the Opportunity Fund as measured on the last day of the first 6-month period of the taxable year of the Opportunity Fund, and on the last day of the taxable year of the Opportunity Fund. If the Opportunity Fund does not meet the 90% threshold at those times, the Opportunity Fund must pay a penalty for each month it fails to meet the 90% threshold. The Proposed Regulations provide some timing relief for eligible entities formed in the first six months of a calendar year. However, the last day of the taxable year will always be a testing date for purposes of the 90% asset test. For example, an Opportunity Fund formed on October 1, 2018 must hold at least 90% of its assets in QOZ Property located in an Opportunity Zone by December 31, 2018. Since December 31 is always a testing date for the 90% test, a taxpayer interested in forming an Opportunity Fund will likely wait until 2019 to form the Opportunity Fund.
Since developing, constructing, and rehabilitating real estate may take longer than six months, real estate commenters believed that Opportunity Funds investing in real estate projects should be afforded additional time to comply with the 90% asset test. Those commenters also recommended that cash should be considered QOZ Property for purposes of the 90% asset test if the cash was held with the intent of investing in QOZ Property. Although the Proposed Regulations do not provide any time extensions for purposes of satisfying the 90% asset test, the Proposed Regulations include a working capital safe harbor for Opportunity Fund investments in a qualified opportunity zone business (“QOZ Business”) that acquires, constructs, or rehabilitates tangible business property, including real property and other tangible property used in a business operating in an Opportunity Zone. If certain requirements are met, a QOZ Business can treat cash held by such business as working capital for up to 30 months.
An Opportunity Fund must invest in QOZ Property. Under Section 1400Z-2(d)(2), QOZ Property includes qualified opportunity zone business property (“QOZ Business Property”), qualified opportunity zone stock, and a qualified opportunity zone partnership interest. Section 1400Z-2(d)(2)(D) discusses the requirements of QOZ Business Property. To be considered QOZ Business Property, the original use of QOZ Business Property must commence with the Opportunity Fund (or QOZ Business) or the Opportunity Fund (or QOZ Business) must substantially improve the property. Under Section 1400Z-2(d)(2)(D)(ii), property is substantially improved only if “during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the [Opportunity Fund] exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the [Opportunity Fund].” The Proposed Regulations address the substantial improvement requirement with respect to a purchased building located in an Opportunity Zone. Since land can never have its original use commence with an Opportunity Fund, the Proposed Regulations and Revenue Ruling 2018-29 clarify that the basis attributable to the land on which the purchased building sits will not be taken into account in determining whether the building has been substantially improved. In order to satisfy the substantial improvement requirement, an Opportunity Fund only needs to invest an amount exceeding the adjusted basis of the building at the beginning of the 30 month period. An Opportunity Fund is not required to separately substantially improve the land.
The goal of the Opportunity Zone program is to encourage economic growth and investment in Opportunity Zones. The Proposed Regulations clarified numerous issues that were unresolved by the text of Section 1400Z-2. Beginning in 2019, it is anticipated that an Opportunity Fund will become a viable investment opportunity for taxpayers looking to defer the incurrence of the capital gains tax.
Public Law 115-97, more commonly known as The Tax Cuts and Jobs Act, added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code (the “Code”). Sections 1400Z-1 and 1400Z-2 allow a taxpayer to defer paying taxes on capital gains by investing such capital gains in a Qualified Opportunity Fund (“Opportunity Fund”) holding certain property in a Qualified Opportunity Zone (“Opportunity Zone”). The Opportunity Zone program should encourage investment in low-income communities.
An Opportunity Zone is a nominated population census tract that is considered a low-income community. Under Section 45D of the Code, a low-income community includes any population census tract with a poverty rate of at least 20%. The governor of each state can nominate up to 25% of the low-income communities within the state as Opportunity Zones. In June, the Department of the Treasury and the Internal Revenue Service finalized the list of Opportunity Zones. Opportunity Zones are located in all 50 states, the District of Columbia, and five United States territories. In Florida, Governor Rick Scott designated 427 communities as Opportunity Zones, including 26 communities in Palm Beach County. The Opportunity Zone designation remains effective until December 31, 2028.
A taxpayer invests in an Opportunity Zone by purchasing an interest in an Opportunity Fund. An Opportunity Fund is an investment vehicle organized as a corporation or a partnership that holds at least 90% of its assets in qualified opportunity zone property (defined below) located in an Opportunity Zone. Under Section 1400Z-2(d)(1), this 90 percent threshold is determined by averaging the percentage of qualified opportunity zone property held in the Opportunity Fund as measured on the last day of the first 6-month period of the taxable year of the Opportunity Fund, and on the last day of the taxable year of the Opportunity Fund. If the Opportunity Fund does not meet the 90 percent threshold, Section 1400Z-2(f)(1) states that the Opportunity Fund must pay a penalty for each month it fails to meet the 90 percent threshold in an amount equal to the product of the excess of the amount equal to 90 percent of its aggregate assets, over the aggregate amount of qualified opportunity zone property held by the Opportunity Fund, multiplied by the underpayment rate established under Section 6621(a)(2) for such month. For any Opportunity Fund organized as a partnership, it appears that each partner must pay a proportionate share of this penalty.
An Opportunity Fund must invest in qualified opportunity zone property. Under Section 1400Z-2(d)(2), qualified opportunity zone property includes qualified opportunity zone business property, qualified opportunity zone stock, and a qualified opportunity zone partnership interest. However, an Opportunity Fund cannot invest in another Opportunity Fund. Section 1400Z-2(d)(2)(D) discusses the requirements of qualified opportunity zone business property (“Opportunity Zone Property”). First, Opportunity Zone Property can be any tangible property used in a trade or business of the Opportunity Fund if the property was acquired by the Opportunity Fund by purchase (as defined in Section 179(d)(2) of the Code) after December 31, 2017. Next, the original use of such property must commence with the Opportunity Fund or the Opportunity Fund must substantially improve the property. Under Section 1400Z-2(d)(2)(D)(ii), property is substantially improved only if “during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.” Finally, substantially all of the use of the Opportunity Zone Property must be in an Opportunity Zone during substantially all of the time the Opportunity Fund holds such Opportunity Zone Property.
Section 1400Z-2(d)(2)(B) and (C) define qualified opportunity zone stock and qualified opportunity zone partnership interest. The definitions are substantially similar. Qualified opportunity zone stock is any stock in a domestic corporation operating as a qualified opportunity zone business if such stock was acquired by the Opportunity Fund after December 31, 2017 at its original issue (directly or through an underwriter) from the corporation solely in exchange for cash. A qualified opportunity zone partnership interest is any capital or profits interest in a domestic partnership operating as a qualified opportunity zone business if such interest was acquired by the Opportunity Fund after December 31, 2017 from the partnership solely in exchange for cash. At the time the qualified opportunity zone stock (or partnership interest) is acquired and during substantially all of the Opportunity Fund’s holding period of such stock (or partnership interest), the corporation (or partnership) must operate as a qualified opportunity zone business. If a corporation (or partnership) is a new entity, such entity must be organized as a qualified opportunity zone business.
Section 1400Z-2(d)(3) lists the requirements of a qualified opportunity zone business. First, substantially all of the tangible property owned or leased by the entity must be Opportunity Zone Property. A qualified opportunity zone business must also generate at least 50 percent of its total gross income from the active conduct of its business and a substantial portion of its intangible property must be used in the active conduct of its business. Furthermore, less than five percent of the average of such business’s aggregate unadjusted property bases may be attributable to nonqualified financial property. Most trades or businesses can be a qualified opportunity zone business. However, a qualified opportunity zone business does not include a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store whose principal business is the sale of alcoholic beverages for consumption off premises.
If a taxpayer realizes a capital gain on the sale or exchange of any capital asset to any unrelated person, the taxpayer can defer the gain recognition event by investing the proceeds in an Opportunity Fund. A taxpayer can defer capital gains up to the amount of the capital gains proceeds invested in an Opportunity Fund. A taxpayer must invest in an Opportunity Fund within 180 days from date of the sale or exchange of the capital asset. The taxpayer who sold the capital asset must be the taxpayer investing in the Opportunity Fund. However, when a partnership or S corporation is the taxpayer selling the capital asset, Sections 1400Z-1 and 1400Z-2 do not clarify whether only the entity itself can invest in an Opportunity Fund.
Under Section 1400Z-2(b), the deferred capital gains will be recognized at the earlier of December 31, 2026 or the date on which the investment in the Opportunity Fund is sold or exchanged. The deferred gain will be taxed at the rate in effect for the year in which the gain is recognized. Although a taxpayer can hold an Opportunity Fund interest after December 31, 2026, the taxpayer must recognize any deferred gain on that date, which creates a phantom income issue. Except as provided below, the taxpayer’s basis in an Opportunity Fund interest will be zero. A taxpayer can increase their basis by holding the Opportunity Fund interest for at least five years. If a taxpayer holds the Opportunity Fund interest for five years, the taxpayer receives a basis increase from zero to 10% of the deferred gain invested in the Opportunity Fund. Thus, 10% of the deferred gain will be permanently forgiven upon the sale of the Opportunity Fund interest. If a taxpayer holds the Opportunity Fund interest for seven years, the taxpayer receives a basis increase in the Opportunity Fund interest equal to 15% of the deferred gain invested in the Opportunity Fund. A taxpayer must invest in an Opportunity Fund by 2019 in order to take advantage of the 15% basis increase.
If a taxpayer holds the Opportunity Fund interest for ten years, Section 1400Z-2(c) provides that the taxpayer will be eligible for a basis increase equal to the fair market value of the investment on the date that the investment is sold or exchanged. The complete basis step-up can only be obtained if the taxpayer holds the interest in the Opportunity Fund through December 31, 2026. Although the taxpayer must recognize the deferred gain (as phantom income) on December 31, 2026, it appears the taxpayer will not be taxed on any further appreciation in the Opportunity Fund interest upon the ultimate sale of such interest.
The new Opportunity Zone program allows a taxpayer to receive preferential tax treatment in exchange for investing in a Qualified Opportunity Fund. A taxpayer can defer paying taxes on capital gains and potentially wipe out any future appreciation on the Qualified Fund interest if the taxpayer holds the interest for ten years. Due to the aforementioned tax benefits, the Opportunity Zone program should encourage investment in low-income communities.
The owners of pass-through entities: partnerships (including limited liability companies—LLCs—taxed as partnerships) and S corporations, must pay tax on their share of the entities’ profits, irrespective of whether the pass-through entity distributes any of those profits to the owners. This disconnect creates the possibility of “phantom income”—taxable income without a matching distribution of cash—for the owners. Since pass-through entities have no statutory obligation to make distributions to cover their owners’ tax liabilities, the owners must address this issue when negotiating their partnership, LLC, and shareholders’ agreements.
Those negotiations often result in a tax distribution provision that requires the pass-through entity to make cash distributions intended to enable the owners to pay their tax liability; however, unless the tax distribution provision is drafted carefully, it may undermine the economics of the deal the parties agreed to. Here is a list of things to things to consider when negotiating a tax distribution provision:
 See Interactivecorp. v. Vivendi Universal, S.A., C.A. No. 20260 (Delaware Chancery Court (July 6, 2004)) , 2004 WL 1573963.
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the “Act”). The Act makes significant changes to federal tax law. As a result of these changes, your estate plan should be examined to determine whether your estate plan remains consistent with your dispositive intent and whether your estate planning documents produce optimal tax results. This is particularly true for married couples with a combined net worth in excess of $5 million. Under the Act, there is no “one size fits all” approach. Rather, the approach needs to be tailored to a client’s individual situation and wishes.
Tax Law Changes
The Act doubles the unified estate and gift tax exemption and GST tax exemption from $5 million to $10 million. This amount is indexed for inflation. Thus for, 2018, this amount is $11.18 million. The increased exemption sunsets (goes away) in 2026 and the prior exemption amounts will be restored. As a result of these increases, fewer taxpayers will be subject to transfer tax.
No change is made to the exemption amounts available to nonresident aliens. Unless a treaty applies, the estate tax exemption available to a nonresident alien is $60,000.
The Act changes the inflation index so that future inflation adjustments will be smaller. Further, this change in the inflation index will not sunset in 2026.
The Act makes no change to the 40% federal estate gift and GST tax rate, the full “step-up” in the basis of a decedent’s assets for income tax purposes or the portability of a married decedent’s unused estate and gift tax exemption amount that was introduced in 2011.
Review Formula Gifts
Many estate plans use formula clauses that are tied to these exemption amounts. These formula clauses should be reviewed to ensure that they remain consistent with intent and are necessary as a result of portability.
For example, a typical estate plan in the past was for married clients to provide in their estate plan that the exemption amount passed to a “family” or “credit shelter” which permitted current distributions to both the surviving spouse and the descendants and the balance of the deceased spouse’s asset to a marital trust which only permitted current distributions to the surviving spouse. With the increase in the exemption, much less or even no assets at all may pass to the marital trust leaving the surviving spouse’s lifestyle in jeopardy.
Further, an estate plan for some clients might leave the GST exemption amount to trusts for grandchildren and the balance to trusts for children. With the increase in exemption, the children may now be disinherited.
These formula clauses should be examined to ensure that a client’s intent is being carried out. Clients may want to consider imposing caps. Alternatively, and perhaps necessitating the greatest number of changes in current estate plans, married clients may decide that achieving a step up in basis on the second death is important and decide to have all assets pass to a marital trust to minimize the imposition of unnecessary federal income tax.
For example, let us assume that Husband dies owning a piece of property that was purchased for $600,000 but is worth $2,000,000 upon Husband’s death. If his surviving spouse sold the property for $2,000,000, because the basis of such property “steps up” to the fair market value at the time of Husband’s death, there would be no income tax gain. However, upon Wife’s death, if the property passed to the Credit Shelter Trust, had not yet been sold and was worth $3,000,000 at her death, there would be a $1,000,000 income tax gain (the difference between $3,000,000 and $2,000,000). If instead the property were placed in the Marital Trust, the property would receive a basis step up for a second time upon the Wife’s death. For married clients whose assets are worth between $5,000,000 and $20,000,000 attention to this change in the tax law is perhaps most critical.
Finally, it will be important in the future to build flexibility into estate plans as the transfer tax rules will change in 2026, if not earlier.
Planning with Increased Exemptions
In making planning decisions concerning the increased exemptions, taxpayers need to consider the potential tradeoffs. With gifted assets, the donee takes the donor’s income tax basis, while assets retained until death receive a step-up in income tax basis. Thus, in making gifting decisions, priority should be given to using high basis assets.
If a taxpayer is holding promissory notes from prior estate planning transactions, forgiving these notes should be given consideration as a manner of using this increased basis.
If a trust holds assets that are subject to GST tax, consideration should be given to making a late allocation of GST exemption. Further, if a trust does not provide for generation-skipping, consideration should be given to decanting the assets to a new trust which is a generation-skipping trust.
Selling assets to grantor trusts will continue to be a viable technique as will establishing a grantor retained annuity trust (“GRAT”). With a sale to a grantor trust, a taxpayer sells an interest in a family business entity to a grantor trust in exchange for a promissory note. A grantor trust is a trust where the trust assets are treated for federal income tax purposes as owned by the grantor. Thus, the sale is ignored for federal income tax purposes, as is the payment of interest by the grantor trust to the grantor. A minimum interest rate must be charged based upon treasury obligations. All growth in the value of the sold assets in excess of this minimum interest rate passes tax free.
With a GRAT, a donor makes an immediate gift of an asset to a trust where the donor retains an annuity interest for a term of years. The amount of the gift is the actuarial value of the remainder interest, which can be made very small. The IRS assumes that the assets will grow at a certain rate which varies monthly based upon treasury obligations. The April 2018 assumed rate is 3.2%. Any growth in excess of 3.2% passes tax-free to the remainder beneficiaries.
Finally, making gifts will remain an option. While taxpayers may not want immediately to make gifts, if the law has not changed by 2025, then taxpayers who will be affected by a decline in the exemption will need to consider whether gifting is appropriate in order to be able to lock in the benefit of the increased exemption before the exemption returns to pre-Act levels. This will be similar to the situation that taxpayers faced in 2012 when the $5 million transfer tax exemption was scheduled to fall to $1 million. Congress did not act to retain the $5 million exemption until January 1, 2013.
The Act expands the benefits of 529 plans. For distributions after December 31, 2017, the definition of “qualified higher education expenses” has been expanded to include tuition at an elementary or secondary public, private, or religious school, and various expenses associated with home school, up to a $10,000 limit per tax year.
 With portability, the surviving spouse’s exemption is increased by the unused portion of the deceased spouse’s exemption.
The passage of the new tax bill was highly publicized. This post focuses on ten potentially overlooked aspects of the new tax bill that may impact an individual’s 2018 income tax return. Remember, these new laws do not affect the 2017 individual income tax return.
1. All miscellaneous itemized deductions subject to the 2% of adjusted gross income floor are now suspended until 2026. For example, an individual cannot claim a deduction for investment management and consulting expenses or tax preparation expenses.
2. Beginning in 2018, an individual cannot claim a deduction for personal casualty and theft losses unless such losses occur in a presidentially-declared disaster. The personal casualty and theft loss deduction will be reinstated in 2026.
3. For any divorce or separation instrument executed after December 31, 2018, the payor-spouse will not be able to deduct alimony payments, which means the recipient will not include alimony payments in gross income. This new law does not retroactively apply to any divorce or separation instrument currently in existence. If a divorce or separation instrument is executed on or before December 31, 2018 but is modified after that date, the payor-spouse cannot claim the alimony payment deduction if the modification expressly provides that this new law applies to the modified instrument.
4. Beginning in 2018, an individual cannot deduct any business-related expenses for entertainment, amusement, or recreation. Previously, an individual could deduct 50% of such business-related entertainment expenses. It should be noted that commentators have disagreed about whether an individual who pays for a client meal at a restaurant is still entitled to a 50% deduction. Ideally, the Internal Revenue Service will provide more guidance on this issue in the upcoming months.
5. Beginning in 2018, there is a 50% limitation on an employer’s deduction for food and beverage expenses provided to employees that can be excluded from an employee’s income as a de minimis fringe benefit. Previously, an employer could deduct 100% of such expenses. After December 31, 2025, an employer will not be allowed to deduct such expenses.
6. Beginning in 2018, a married joint filing individual can 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 individual can elect any combination of those taxes to reach the $10,000 limit. Previously, there was no limit on the state and local tax deduction. The new limit on the state and local tax deduction sunsets after 2025. Unless Congress approves an extension of this law, the unlimited state and local tax deduction will be reinstated in 2026.
7. For the 2017 and 2018 tax years, an individual may claim an itemized deduction for unreimbursed medical expenses only to the extent that such expenses exceed 7.5% of adjusted gross income. Previously, an individual under the age of 65 could take this deduction only to the extent that such expenses exceeded 10% of adjusted gross income. Starting in 2019, the 10% threshold will be reinstated for such individuals.
8. 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. Previously, an individual could take a deduction of up to 50% of the individual’s adjusted gross income for cash contributions made to public charities.
9. Beginning in 2018, an individual will not get a charitable deduction for any payments to a college in exchange for the right to purchase tickets for collegiate athletic events.
10. Beginning in 2018, a Section 529 plan can distribute up to $10,000 per year in expenses for tuition incurred in connection with the enrollment or attendance at a public, private, or religious elementary or secondary school. These expenses may be distributed from kindergarten through the 12th grade. Previously, a Section 529 plan could only be used for qualified higher education expenses.
Some people assume that if they are unable to make decisions or if a decision relates to “end of life,” that those closest to them, most often immediate family members, automatically make these decisions on their behalf. Others are aware that to carry out their directives that they need to sign documents generally known as Health Care Surrogates and Living Wills but aren’t quite sure of the difference between the two documents. Clients regularly ask – “what is the difference between a Health Care Surrogate and a Living Will, and why do I need both of these documents?”
Every competent adult in Florida has the fundamental right to make decisions pertaining to his or her own health, including the right to choose or refuse medical treatment. In order to ensure that this right is not diminished or even lost as a result of a person’s incapacity, the Florida legislature has codified the requirements for the creation of two different documents to facilitate medical decisions – the Health Care Surrogate and the Living Will. The Florida legislature has prescribed specific requirements for both the content and execution of these documents to be accepted by hospitals and physicians, and enforceable under the law.
The document which nominates a person to make medical decisions for you is called your Designation of Health Care Surrogate. This person(s), known as your Health Care Surrogate, is permitted to receive all of your health information relating to past, present or future physical or mental health as well as make health care decisions, give consent on your behalf for medical treatment, make anatomical gifts, etc. Your designation of health care surrogate needs to be signed by you in the presence of two witnesses (who also sign the document), who ideally are not related to you. Additionally, you should also designate an alternative surrogate if the original surrogate is not willing, not able or unavailable to perform the required duties.
The Living Will is a document generally used only to direct the providing, withholding or withdrawal of life-prolonging procedures in the event that such person has an end-stage condition or is in a persistent vegetative state. Two physicians, one being the patient’s primary physician, must separately examine the patient and conclude that death is clearly imminent before life-prolonging procedures may be withheld or withdrawn. In order to be effective, Florida law dictates that a living will be signed in the presence of two witnesses (who also sign the document) and again, ideally, these witnesses should, although one does not have to, be unrelated to the person signing the living will. In the absence of a living will, the designated health care surrogate will generally be entitled to make end of life decisions.
You may also hear the term “advance directive” in association with a living will or a designation of health care surrogate. Both the living will and the health care surrogate are themselves types of advance directives under Florida law. (Florida Statutes § 765.101(1)).
It is important to note that if an advance directive is executed in another state and is in compliance with the laws of that state, Florida physicians will generally be required to follow such directive. For example, if you executed a living will in New York that follows New York law, Florida physicians should honor your New York living will.
Most importantly, if you want your health care and end of life wishes carried out, it is imperative that you have both the Health Care Surrogate, and if appropriate, a separate Living Will.
We hope this discussion has been helpful. We encourage you to contact us for any clarification.
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.
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.
|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 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 “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. 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.
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.
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.
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).
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!
After the House of Representatives and Senate passed different versions of the “Tax Cuts and Jobs Act,” a conference committee was appointed to reconcile the two tax bills. On December 13, 2017, the conference committee reached a consensus on a revised “Tax Cuts and Jobs Act.” Both chambers must pass the “Tax Cuts and Jobs Act” by a majority vote before President Trump can sign it into law. On December 20, 2017, the Senate passed the bill by a vote of 51-49. The House is expected to pass the tax bill later this week. “Tax Reform Now” will highlight the relevant changes for individuals, corporations, pass-through businesses, and estates.
The “Tax Cuts and Jobs Act” retains seven income tax brackets, but it will change the income tax rates. The seven income tax brackets will be 10%, 12%, 22%, 24%, 32%, 35%, and 37%. To comply with the budget reconciliation rules, the lower income tax rates will begin in 2018 and sunset after 2025. Due to the changes made by Congress, many taxpayers will no longer itemize their deductions. The alimony payment deduction will be repealed. As a result, an ex-spouse will not include alimony payments in gross income. This law will apply to any divorce or separation instrument executed after December 31, 2018. Under the tax bill, a taxpayer will be able to take a maximum $750,000 deduction for home mortgage interest on a newly purchased home. This maximum deduction is lower than the currently allowable $1 million deduction for home mortgage interest. A taxpayer will be allowed to deduct up to $10,000 for state and local property taxes and either state income or sales taxes. This tax bill will also repeal the Obamacare penalty tax for taxpayers who fail to buy health insurance beginning in 2019.
Corporations receive favorable treatment under the tax bill. The corporate income tax rate will be cut from 35% to 21% for tax years beginning in 2018. The corporate income tax rate change will be permanent. The corporate alternative minimum tax will be repealed.
The “Tax Cuts and Jobs Act” will not create a new maximum tax rate for pass-through business owners. However, most pass-through business owners will be able to deduct 20% of their non-wage portion of business income. After this deduction is taken, the pass-through owner will pay income taxes at the new individual income tax rates. Trusts or estates with ownership interests in pass-through businesses will be entitled to take this deduction. However, this deduction is generally not available for pass-through business income from a “specified service trade or business.” A “specified service trade or business” includes a trade or business “involving the performance of services in the fields of health, law, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” For pass-through business owners in a “specified service trade or business,” this deduction is available only if the pass-through business owner’s taxable income is not more than $157,500 for single filers and $315,000 for married joint filers. 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.
Although the estate tax will not be eliminated, almost all estates will no longer pay the federal estate tax. Beginning in 2018, an unmarried individual’s estate, gift, and generation-skipping transfer tax exclusions will be doubled to almost $11 million. The exclusions for married couples will approach $22 million. The doubling of the exclusions will sunset after 2025.
We hope this update has been helpful. As always, please let us know if you have any questions.
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.
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.
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.
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 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.
On November 2nd, the House Ways and Means Committee unveiled the first draft of the “Tax Cuts and Jobs Act.” The House Ways and Means Committee will revise the “Tax Cuts and Jobs Act” during its mark-up session beginning on November 6th. However, the initial draft of the “Tax Cuts and Jobs Act” includes impactful changes to the Internal Revenue Code. “Tax Reform Now” will briefly highlight some relevant changes.
Corporate Income Tax Brackets
Current Law – There are seven income tax brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.
Proposed Law – There will be four income tax brackets: 12%, 25%, 35% and 39.6%.
Estate and Gift Tax
Current Law – A taxpayer can pass (during life or upon death) up to $5.49 million to his or her heirs without paying any federal estate tax (married couples can pass up to $10.98 million). If a taxpayer owns more than that, upon his or her death, the estate must pay a federal estate tax of 40%.
Proposed Law – The estate, gift and generation – skipping transfer tax exclusions doubles to almost $11 million beginning in 2018. That is, a taxpayer can pass up to $11 million to his or her heirs without paying federal estate tax and married couples will be able to pass up to $22 million. Please note that the estate tax will be phased out beginning in the 2024 tax year. Additionally, beginning in 2024, the top gift tax rate would be lowered to 35%.
Current Law – Sole proprietorships, partnerships, limited liability companies, and S corporations are generally treated as pass-through businesses subject to tax at the individual owner or shareholder level. Thus, an individual owning an interest in a pass-through business is taxed on any business profits at their own individual income tax rate. The maximum individual income tax rate is 39.6%.
Proposed Law – For a pass-through business that distributes net income to an individual, a portion of the distributed net income will be treated as “business income.” The maximum tax rate on this portion of “business income” will be 25%. The remaining portion of net income distributed to an individual will be compensation subject to the individual income tax rates.
Corporate Income Tax Brackets
Current Law – The maximum corporate tax rate is 35%.
Proposed Law – Starting in 2018, the corporate tax rate will be a flat 20% rate. However, personal service corporations will be subject to a 25% corporate tax rate.
State and Local Tax (“SALT”) Deduction
Current Law – An individual must itemize their deductions in order to take the SALT deduction. The SALT deduction allows an individual to deduct state and local property taxes along with state and local income taxes or sales taxes from their federal income tax bill.
Proposed Law – An individual can deduct state and local real property taxes up to $10,000. An individual will not be allowed to deduct state and local income taxes or sales taxes. By capping the amount of the SALT deduction, more individuals will switch from itemizing their deductions to utilizing the larger standard deduction.
401(k) Plans and Individual Retirement Accounts
The “Tax Cuts and Jobs Act” will not substantively alter the tax treatment of 401(k) plans and Individual Retirement Accounts.
We hope this update has been helpful. As always, please let us know if you have any questions.
As explained in Part 2 of “Tax Reform Now”, Republican lawmakers sought an outright repeal of the state and local tax deduction (“SALT deduction”) in order to offset tax cuts. After encountering criticism from both political parties and lobbyists, Republican lawmakers have renounced this position. Although the new tax reform bill has not been released, Kevin Brady, the Chairman of the House Ways and Means Committee, announced that the SALT deduction will be included in the tax reform bill. A taxpayer who itemizes their deductions can currently take the SALT deduction. The SALT deduction allows a taxpayer to deduct state and local property taxes along with state and local income taxes or sales taxes. It is unclear how the SALT deduction will change in the new tax reform bill. The details of the new tax reform bill will be announced this week. Following this announcement, “Tax Reform Now” will explain the new SALT deduction and its effect on taxpayers.
We hope this update has been helpful. As always, please let us know if you have any questions.
On October 26th, the House of Representatives approved the budget resolution previously passed by the Senate. Because the House approved the Senate’s budget resolution without making any changes, a conference committee will not be necessary. Avoiding a conference committee speeds up the timeline for tax reform. The budget resolution passed 216-212 in the House. All Democrats and 20 Republicans voted against the budget resolution. As expected, most Republicans who voted against the budget resolution were those who do not want the state and local tax deduction (“SALT deduction”) to be eliminated or scaled back. Repealing the SALT deduction in its entirety could generate more than $1 trillion in revenue that would help offset the proposed tax cuts. Part 2 of “Tax Reform Now” describes why repealing the SALT deduction is a contentious issue. Since the budget resolution included the budget reconciliation instructions, a tax reform bill can now be approved by a majority vote in the Senate. Part 5 of “Tax Reform Now” explains in greater detail how the budget reconciliation instructions impact long-term tax reform.
Republican leaders want to pass a tax reform bill through Congress before Thanksgiving. Thus, Republicans have approximately three weeks to achieve this goal. Because the Senate’s budget resolution was passed by the House, the House and Ways Means Committee is now tasked with drafting the tax reform bill. Kevin Brady, the House Ways and Means Committee Chairman, announced that a draft of the tax reform bill should be released on November 1st. After this draft is released, the House Ways and Means Committee will hold a mark-up session starting on November 6th. In a mark-up session, the House Ways and Means Committee members will debate, propose amendments, and rewrite the proposed tax reform bill. While this mark-up session is going on, the Senate Finance Committee will be gearing up for its own mark-up session.
Since the release of President Trump’s framework for tax policy reform in late September, the details of any tax reform legislation have been shrouded in mystery. Republican leaders have not yet reached a consensus on thorny issues. Nevertheless, the House Ways and Means Committee’s draft of the tax reform bill will provide answers for individuals and businesses anticipating significant tax changes. When the draft of this tax reform bill is released, “Tax Reform Now” will provide a summary of the proposed changes.
We hope this update has been helpful. As always, please let us know if you have any questions.
On October 19th, the Senate approved a $4 billion budget resolution, which now paves the way for passage of a tax bill using the budget reconciliation rules. This budget resolution passed 51-49 in the Senate, with Rand Paul being the lone Republican Senator to vote against it. As mentioned in Part 3 of “Tax Reform Now,” the House of Representatives previously passed a budget resolution with budget reconciliation instructions. The House’s budget resolution stated that any tax cuts must be offset by tax increases or spending cuts. The Senate’s budget resolution did not follow the House’s philosophy. Instead, the Senate’s budget resolution would add $1.5 trillion to the federal deficit over the next ten years.
The most important aspect of the Senate’s budget resolution is its inclusion of budget reconciliation instructions. These instructions allow a future tax bill to pass by a simple majority vote in the Senate. Typically, the political party in the Senate minority can filibuster a bill unless there are 60 votes to break the filibuster. By including the budget reconciliation instructions in the budget resolution, a future tax bill cannot be filibustered by Democrats if the tax bill adds $1.5 trillion or less to the federal deficit. There is a drawback to enacting tax reform using budget reconciliation. If a tax bill is passed using budget reconciliation, the Senate rules do not allow the tax bill to increase the federal deficit beyond the first ten years after its enactment. Like the Bush administration’s tax cuts enacted using budget reconciliation in the early 2000s, any tax cuts would be temporary and “sunset” after ten years.
Before the budget reconciliation instructions take effect, the House and Senate must pass identical budgets. Interestingly, the Senate’s budget resolution includes an amendment that allows the House to adopt the Senate’s version of the budget. Either the House will pass the Senate’s budget resolution without making any changes, or the budget resolution will go to a conference committee between the two chambers. It is common for a budget resolution to go to a conference committee. A conference committee usually takes a week or two to resolve any differences. However, the Senate’s budget resolution is expected to pass the House without the need for a conference committee because the Senate’s budget resolution included amendments that appeased House Republicans. Avoiding a conference committee speeds up the timeline for tax reform. If the Senate’s budget is passed by the House, the House Ways and Means Committee will draft the tax reform legislation. Republican leaders hope that the tax bill will be ready to be presented to the House by early November.
We hope this update has been helpful. As always, please let us know if you have any questions.
A Compromise on the State and Local Tax Deduction?
There has not been much progress in the last week with respect to President Trump’s plan for tax reform, except with respect to the state and local tax deduction (“SALT deduction”). The debate over the future availability of the SALT deduction has been an initial obstacle for Republican lawmakers attempting to reach an agreement on tax reform. Part 2 of “Tax Reform Now” discussed why potentially repealing the SALT deduction is a contentious issue. Instead of an outright repeal of the SALT deduction, Republican lawmakers are now exploring other options. One option gaining traction is making the SALT deduction available to taxpayers earning less than a specified amount of income. Taxpayers earning more than this income threshold would no longer be able to take the SALT deduction. Although an exact amount has not been specified, recent discussions have an amount somewhere between $200,000 and $400,000 as the income threshold. However, the final decision regarding the SALT deduction will not be known until the House of Representatives introduces its tax bill.
2704 Proposed Regulation
Although not related to the current tax reform initiative in Washington, we wanted to let you know that on October 3, 2017, the Treasury Department withdrew Proposed Treasury Regulations to Section 2704 of the Internal Revenue Code issued last year. Had they been finalized, the Proposed Regulation would have reduced or eliminated the ability to use minority-interest and marketability discounts for transfers of interests in family controlled entities. The Treasury Department withdrew the Proposed Regulation citing, “the Proposed Regulation’s approach to the problem of artificial valuation discounts is unworkable.”
We hope this update has been helpful. As always, please let us know if you have any questions.
On October 5, the House of Representatives took the first step in overhauling the United States tax code when it passed a budget resolution. This budget resolution would allow a future tax bill to pass in the House and the Senate without the support of any Democrats. In a 219 to 206 vote, 18 Republicans and all Democrats voted against the House’s budget resolution. As discussed in last week’s edition of “Tax Reform Now”, some Republican Representatives voted against the budget resolution because of the potential repeal of the state and local tax deduction. The House’s budget resolution now serves as a blueprint for federal spending during the 2018 fiscal year. This week’s edition of “Tax Reform Now” will discuss the reconciliation language in the House’s budget resolution along with the next steps that legislators will take.
The House’s budget resolution includes language for a procedure called reconciliation, which will allow a future tax bill to avoid a filibuster in the Senate. Instead of needing 60 votes to overcome a filibuster, Republicans can pass a tax bill in the Senate with 51 votes. If there is a tie, Vice President Pence would then cast the deciding vote. This parliamentary language was added because the Republicans only hold 52 seats in the Senate. However, in order to use reconciliation and avoid a filibuster, the House and Senate must first agree on an identical budget resolution for the 2018 fiscal year. If the House and Senate can decide on an identical budget resolution, a tax bill that satisfies the approved budget conditions will avoid a filibuster.
The House’s budget resolution discusses how to eliminate annual budget deficits by the end of the decade. The House assumes its proposed budget resolution will not add to the federal deficit by providing $203 billion in spending cuts. The Senate Budget Committee has advanced its own budget resolution, which would allow legislators to add up to $1.5 trillion to the budget deficit. The Senate Budget Committee’s resolution must be approved by the Senate. The Senate will vote on this budget resolution next week. If the Senate passes this budget resolution, the House would need to pass the Senate’s version of the budget without making any changes, or else the budget must go to a conference committee to resolve any differences. The House and Senate would vote again on the budget resolution offered by the conference committee. If the budget resolution is approved by the House and Senate, the House Ways and Means Committee would then meet to draft a tax bill.
We hope this update has been helpful. As always, please let us know if you have any questions.
“Repeal of the State and Local Tax Deduction?”
As mentioned in last week’s edition of “Tax Reform Now,” President Trump’s “Unified Framework for Fixing Our Broken Tax Code” would eliminate most itemized deductions. Although the home mortgage interest and charitable contribution deductions would be retained, this framework would eliminate the widely used state and local tax deduction (“SALT deduction”). The Trump administration believes the revenue generated from eliminating the SALT deduction would help defray the costs of other proposed tax cuts in the framework. Proponents of eliminating the SALT deduction argue that taxpayers living in states that impose less state and local taxes currently subsidize taxpayers living in states that impose more state and local taxes. Merely talking about eliminating the SALT deduction has triggered backlash from both political parties. As a result, the SALT deduction may be used as a potential bargaining chip in ongoing discussions between Republicans and Democrats.
The SALT deduction can be taken by a taxpayer who itemizes their deductions. The SALT deduction allows a taxpayer to deduct property taxes along with state and local income taxes or sales taxes. Due to the availability of this deduction, some states and local governments have imposed more onerous taxes on taxpayers. Wealthy taxpayers living in states that impose more state and local taxes, such as California and New York, can utilize the SALT deduction to reduce their federal income tax bill by the amount paid to their state and local governments. This deduction is typically one of the largest itemized deductions taken by taxpayers. By eliminating the SALT deduction, wealthy taxpayers living in states that impose more state and local taxes would pay more taxes. Less affluent taxpayers living in these states are likely to switch from itemizing their deductions to utilizing the larger standard deduction offered in Trump’s framework. If the SALT deduction is repealed, states and local governments may feel pressure from their constituents to lower state and local taxes.
The states that would be most affected by the elimination of the SALT deduction are traditionally “blue” states. However, Republican politicians from California, New York, New Jersey, and Illinois have spoken out against eliminating the SALT deduction. These politicians do not want their constituents to pay more taxes. They are also apprehensive about not being reelected, which could result in the Republicans losing control over the House of Representatives in 2018. Their resistance has produced immediate results. During this past week, the Trump administration mentioned that eliminating the SALT deduction is a position up for negotiation.
The fate of the SALT deduction may decide whether President Trump has enough clout to enact his proposed tax framework. If the SALT deduction is not completely eliminated, the Trump administration must find other revenue streams to defray their proposed tax cuts. “Tax Reform Now” will provide updates about this contentious deduction when more information is disseminated.
And what happens to basis?
Under the current tax regime, taxpayers receive a step-up in basis when they inherit property. For example, imagine that you inherit a painting today that your mother purchased for $2 million. Now, that painting is worth $20 million. Upon your mother’s death, you receive a step-up in basis to the current fair market value: $20 million. That is, you receive the painting with a basis of $20 million. You avoid recognizing any gain that accrued during the time your mother owned it ($18 million) when you ultimately sell the property. This has been the law for some time.
However, in his campaign, President Trump proposed eliminating the basis step-up for assets exceeding $10 million. At this point, it is not clear whether the proposed framework supports (with respect to the above scenario) (1) an income tax recognition event at death, whereby your mother’s estate would recognize $18 million of gain at her death; or (2) a carry-over of the basis, whereby you would receive the painting with a basis of $2 million (the basis in which your mother had) and when you chose to sell the painting, would recognize whatever the gain is at that time (at its sale price). Clause (1) proposes a deemed recognition event at death for assets exceeding $10 million – this has never been seen before in our tax law. A forced recognition event, as described in clause (1) above would be problematic if the decedent did not have sufficient liquid assets to pay the tax. If that is the case, it will be crucial for individuals who have assets in their estate that have appreciated greatly, along with individuals who have few liquid assets, to plan in advance for more liquidity. A typical planning tool would be to purchase a life insurance policy in an amount sufficient to pay such taxes, whether income or estate (or to continue holding an existing life insurance policy).
Where do we go from here?
A bill regarding tax reform is expected to be introduced in early November. Before the bill can be written, a 2018 budget resolution must be adopted in order for the tax-writing committees to know the financial parameters of the bill. If the House and Senate fail to adopt a budget resolution that is filibuster proof, there will likely be no significant tax reform this year. Additionally, Republican House members have already shown dissidence with the elimination of the state and local tax deduction. A split Republican Party will make it more difficult for any tax legislation to be passed.
We hope this update has been helpful. As always, please let us know if you have any questions.
“Unified Framework for Fixing Our Broken Tax Code”
On Wednesday September 29, 2017, President Trump unveiled a framework for his tax policy reform, entitled the “Unified Framework for Fixing Our Broken Tax Code”. If the tax overhaul takes place as planned, this will be the country’s largest tax reform since 1986. A summary of the proposed major changes follows:
Income Tax Brackets. The framework collapses the seven current individual income tax brackets into three brackets at 12%, 25% and 35%.
Deductions. The framework proposes doubling the standard deduction to $24,000 for married taxpayers filing jointly and $12,000 for single filers. President Trump’s plan additionally eliminates most itemized tax deductions, except for the deduction for mortgage interest payments and charitable deductions.
Estate/Generating Skipping Tax. The framework proposes repealing the estate tax and generation-skipping tax, but does not give any further details of how that will be accomplished.
Alternative Minimum Tax. The framework also proposes repealing the individual alternative minimum tax.
New Tax Structure for Small Businesses. The framework creates a new tax rate structure for small businesses. For small businesses organized as sole proprietorships, partnerships, or S corporations, the maximum tax rate on any business income will be 25%. Individuals owning interests in these pass-through businesses are currently taxed on any business profits at their own individual income tax rates.
Corporations. The framework proposes to lower the top federal tax rate for corporations from 35% to 20%. The corporate alternative minimum tax will also be eliminated. Although no details were provided, the framework suggests that future efforts may be made to reduce the double taxation of corporate earnings.
Elimination of Certain Business Deductions and Credits. The framework expresses the goal of limiting the number of business deductions and credits. The domestic production deduction will be eliminated. The net interest expense deduction taken by C corporations will be partially limited. Although the framework discusses the goal of limiting business credits, the business credits for research and development and low-income housing will be retained.
Immediate Deduction for Purchased Depreciable Assets. Under the framework, companies will be able to immediately write off the entire cost of investments in depreciable assets purchased after September 27, 2017. Companies will be able to take advantage of this immediate deduction for at least the next five years. Companies can currently deduct the cost of depreciable assets over a period of years.
Repatriation of Foreign Profits. To avoid paying the corporate tax on profits earned outside of the United States, United States-owned multinational companies have opted to keep these foreign earnings in overseas tax havens. This framework encourages these multinational companies to return foreign earnings and illiquid assets to the United States. The framework proposes that the United States switch to a territorial tax system, meaning that multinational companies would no longer pay taxes in the United States on any foreign earnings. These multinational companies will only pay taxes to the government of the country where the money was earned. However, multinational companies would be required to pay a one-time repatriation tax on their existing foreign earnings. All foreign earnings will then be treated as repatriated (or returned) to the United States. Foreign earnings will be taxed at different tax rates depending on if the foreign earnings are in cash or illiquid assets. If a company has earnings invested in illiquid assets, the repatriated illiquid assets will be taxed at a lower rate than cash or cash equivalents. Companies will be able to pay this proposed repatriation tax over an unspecified number of years. The framework does not specify the proposed repatriation tax rate.