TAX CUTS and JOBS ACT: A Few Initial Takeaways and Key Changes to Consider
Congress and the President successfully passed new tax legislation, known as the Tax Cuts and Jobs Act (TCJA). The TCJA impacts individuals, as well as businesses large and small. It’s very early in the process, and many of the details are still being sorted out. The IRS will undertake the process of working through the particulars, and they’ll ultimately issue final regulations, which will certainly help clarify planning opportunities. How the changes will impact individuals and businesses is difficult to say, as each particular circumstance is unique.
There are a few clear winners from the TCJA. Corporations stand to benefit from a materially lower income tax rate. Businesses that distribute “pass through” income to their owners are favored. In fact, possibly some of the biggest planning conversations ahead will revolve around business entity selection or related topics. Larger estates will also benefit, given an increase in the exemption amount that can pass to one’s heirs free of the death tax.
For many individuals, the direct benefits of the TCJA are a bit more complicated and dependent on one’s situation. Though there has been plenty of political “hype” in all the discussion, we do agree that all individuals are likely to be indirect beneficiaries of the new law, as corporations and businesses employ some of their tax savings in ways that foster long-term economic growth – more on that below.
Regrettably, the new law does significantly reduce some popular deductions for individuals, including state and local income taxes, sales taxes and property taxes. Thus, for individuals with relatively large itemized deductions, there is a chance they could see taxes increase, in spite of lower tax rates.
Also, despite the perpetual political promise of “simplification”, the tax code will remain as complicated as ever. Thus, planning will remain highly essential, especially considering all of the different effective dates and sunset provisions included in the new law (see chart below). It is also a bit disappointing that provisions like the individual Alternative Minimum Tax (AMT) did not get the axe entirely, but at least there was improvement.
Additionally, with respect to estate planning, it’s important to note that the higher exemption amounts are not permanent. Therefore, there’s at least a decent chance that today’s lower exemption amounts will return. You might recall it wasn’t all that long ago that the exemption amount was less than $1 million, impacting a much higher percentage of individuals. And, even if your estate is well under the new exemption level, there are many reasons, outside of tax considerations, to properly plan your estate.
In general, the new tax legislation has been well received by financial markets. The reduction in the statutory corporate tax rate to 21% makes the United States’ corporate tax structure much more competitive globally. The previous rate of 35% was one of the highest in the developed world. Now, not all large U.S. based companies have been paying the full freight, but still, their effective tax rate is expected to drop between 5 – 6 percentage points, which Wall Street analysts estimate could add about $10 per share to S&P 500 earnings. This improves after-tax earnings and improves free cash available to businesses to reinvest and distribute to shareholders.
Small and mid-size companies – which are not typically included in the S&P 500 – could experience an even greater relative improvement. Exactly how companies plan to use this new windfall is not completely predictable, but it is likely that some of it will be used for accelerated business investment, new hiring, and higher worker pay. Anecdotally, we have already seen a number of one-time bonuses paid out to employees across various industries.
Another, and perhaps underappreciated, aspect of the legislation is the shift to what is referred to as a territorial tax system. After an initial repatriation charge on cash held overseas, companies will henceforth be allowed to return international earnings back to the United States tax free. This is most important to technology, healthcare, and pharmaceutical companies which tend to have the most money held outside of the United States. It wouldn’t surprise us to see an increase in mergers and acquisitions, stock buybacks, and dividends from these sectors.
Let’s discuss and make observations on a few of the details, good and bad… let’s start with the good:
- There are still seven tax-brackets for individuals, but the highest tax rate as well as intermediate rates are now lower than before. The highest rate has dropped from 39.6% to 37%.
- The standard deduction is now higher for both individuals and married taxpayers. One of the most visible and talked about changes is the increase in the standard deduction from $6,500 to $12,000 for individuals and from $13,000 to $24,000 for married couples.
- 529 Education Fund savers can now use up to $10,000 per student per year for public, private or religious elementary or secondary schools, where previously these could only be used for traditional college costs. The $10,000 limitation does not apply for post-secondary school expenses.
- Charitable contributions are still available as an itemized deduction, and the AGI threshold for cash gifts to charity increases from 50% to 60%.
- For individuals age 70 ½ or older, qualified charitable distributions (QCDs) from retirement accounts are still available up to $100,000. Note that QCDs are an above the line deduction for tax purposes, as opposed to an itemized deduction.
- Medical expenses in excess of 7.5% of adjusted gross income are deductible. In the past, the AGI threshold was 10%. (This is a temporary change, for the 2017 and 2018 tax years only).
- The “Pease” limitation, aka the 3% phase-out for itemized deductions above a certain income threshold, have been suspended for 2018-2025. This provides significant relief to taxpayers with higher incomes who previously were losing as much as 80% of the benefit from their itemized deductions.
- Favorable tax rates for long-term capital gains and qualified dividends were unaffected, and tax rates will generally remain subject to a maximum rate of 15% or 20% on higher amounts.
- Proposed legislation requiring investors to sell their oldest, and likely most highly appreciated, shares first did not make it into the final law. Despite much discussion, the 3.8% Medicare Surtax applied to investment income above certain thresholds did not get eliminated.
- Owners of pass-through businesses will be allowed a 20% deduction for qualified business income from a partnership, S-corporation and sole proprietorship. This is for income below certain thresholds ($315,000 for Married Filing Jointly and $157,000 for Individual filers).
- The Alternative Minimum Tax (AMT) system is still in place. However, since it raises the income exemption levels to $70,300 for individuals and $109,400 for married filing jointly, fewer people will be impacted by the tax. (Previously, these exemptions were $54,300 and $84,500 respectively.) This is welcome news for many.
- The Gift & Estate Tax exemption doubles to $10,980,000 per person, and $21,960,000 per married couple. This change eliminates estate tax considerations for a whole new level of taxpayers. The rate for estate taxes remains at 40%, but the higher exemption amounts are scheduled to sunset after 2025.
- Section 179 changed so that businesses can deduct a higher portion of capital investment as a current expense. This amount increased to $1 million from $500,000, while increasing the cost of property subject to the phase-out to $2.5 million from $2.0 million.
And now, the not so good news…
- Not as prominent in discussions as the Standard Deduction is that the Personal Exemption, currently $4,050 per person, is eliminated.
- For alimony paid after December 31, 2018, payments are not deductible by the payer spouse, nor is it includible as income by the payee spouse. This only affects divorces that are finalized beginning in 2019 and will not impact existing alimony arrangements.
- Regarding itemized deductions, there are many changes. Perhaps the most notable being:
- State and local income taxes, property taxes and sales taxes are limited to $10,000 (combined).
- Mortgage interest deductions are capped at interest on $750,000 of acquisition indebtedness for a primary residence and second home (combined) for loans established after December 15, 2017. Debt incurred before this date is “grandfathered” under old rules.
- Interest on HELOC loans is no longer deductible, unless specifically used for home improvement.
- Miscellaneous itemized deductions subject to a 2% floor have been eliminated.
- College Athletic Fund Contributions to athletic funds in exchange for preferred event seating will no longer be deductible.
- Net operating losses (NOLs) are now limited to 80% of taxable income, and the two year-carryback provision, which allowed losses to be calculated against prior year returns, has been eliminated. However, taxpayers can now carry forward NOLs indefinitely instead of the prior limit of 20-years.
There are many additional changes in the TCJA not addressed in this relatively short piece. Thus, we highly recommend visiting with your CPA or other tax advisor as to how these and other changes may impact you personally. And, keep in mind, that the new rules take effect and potentially sunset at different times, making long-term planning difficult at best.
We’re in the very early stages of the game with these new rules, so much is still to be seen. That being said, it’s clear that tax planning and modeling will remain an essential part of any personal financial discussion. This relates to both decisions around personal income and business tax planning, as well as estate tax planning.
To conclude, please keep in mind that this is only a brief summary. It’s a bit staggering that we’ve already seen summaries on the new tax law that are in excess of 150 pages in length. There are many changes and certainly many nuances with the tax code to consider. Again, we highly recommend visiting with your CPA or other tax advisor to ensure you have a good understanding of how the new law will impact you personally.