On December 22, the President signed the Tax Cuts and Job Act (TCJA). This Act has sweeping changes affecting both individuals and businesses. Most of these changes are for tax years 2018 through 2025. To keep you informed, we are highlighting some of the provisions of the TCJA. We have broken down the changes between those affecting individuals and those affecting businesses.
Individual Income Tax Highlights (New Income Rates)
For tax years beginning after December 31, 2017, seven tax rates apply for individuals: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The act also provides four tax rates for estates and trusts: 10%, 24%, 35%, and 37%.
Standard Deduction Increase
For tax years beginning after December 31, 2017, the standard deduction is increased to $24,000 for married individual filing a joint return, $18,000 for head of household filers, and $12,000 for all other taxpayers. These will be adjusted for inflation in tax years beginning after 2018. There were no changes made to the current law additional standard deduction for the elderly and blind.
Personal Exemptions Suspended
For tax years beginning after December 31, 2017, the deduction for personal exemptions is effectively suspended by reducing the exemption amount to zero.
Kiddie Tax Modified
For tax years beginning after December 31, 2017, the taxable income of a child attributable to earned income is taxed under the rates for single individuals. Taxable income of a child attributable to net unearned income is taxed according to the bracket applicable to trust and estates. This rule applies to the child’s ordinary income and his or her income taxed at preferential rates. Previously, the child’s unearned income was taxed at the parent’s tax rate.
Capital Gains Provisions Conformed
TCJA generally retains present-law maximum rates on net capital gains and qualified dividends. It retains the break points that exist under the pre-Act law, but indexes them for inflation in tax years after December 31, 2017. For 2018, the 15% break point is $77,200 of taxable income for joint returns and surviving spouse (half this amount for married taxpayer filing separately), $51,700 for head of household, $2,600 for trusts and estates and $38,600 for unmarried individuals. The 20% break point is $479,000 of taxable income for joint returns and surviving spouses (half of this amount for taxpayers married filing separate), $452,400 for head of household, $12,700 for estate and trusts, and $425,800 for other unmarried individuals.
Deduction for Personal Casualty and Theft Losses Suspended
For tax years beginning after December 31, 2017, the Personal Casualty and Theft Loss deduction is suspended, except for personal casualty losses incurred in federally declared disasters. However, where the taxpayer has a personal casualty gain, the loss suspension does not apply to the extent that such loss does not exceed the gain.
Child Tax Credit Increase
For tax years beginning after December 31, 2017, the Child Tax Credit is increased to $2,000, and other changes are made to phase-outs and refundability during the same period. The income levels at which the credit phases out are increased to $400,000 for married taxpayers filing jointly ($200,000 all other taxpayers). In addition, a $500 non-refundable credit is provided for certain non-child dependents. The amount of the credit that is refundable is increased to $1,400 per qualifying child. This amount is indexed for inflation, up to the base $2,000 credit amount. The earned income threshold for the refundable portion of the credit is decreased from $3,000 to $2,500.
State and Local Tax Deduction Limited
For tax years beginning after December 31, 2017, subject to the exception described below, state, local and foreign property taxes, and state and local sales taxes are deductible only when paid or accrued in carrying on a trade or business or an activity for the production of income. State and local income taxes are not allowable as a deduction.
However, a taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for married taxpayers filing separate) for the aggregate of (i) state and local property taxes not paid or accrued in carrying on a trade or business activity; and (ii) state and local income taxes (or sales taxes in lieu of income) paid or accrued in the tax year.
Mortgage and Home Equity Indebtedness Interest Deduction Limited
For tax years beginning after December 31, 2017, the deduction for interest on home equity indebtedness is suspended and the deduction for mortgage interest is limited to underlying indebtedness of up to $750,000 ($375,000 for married taxpayer filing separately). The new lower limit does not apply to any acquisition indebtedness incurred before December 15, 2017.
Mortgage and Home Equity Indebtedness Interest Deduction Limited – Continued
The one million dollar limitation continues to apply to taxpayers who refinance existing qualified residence indebtedness that was incurred before December 15, 2017, so long as the indebtedness resulting from the refinancing does not exceed the amount of the refinanced indebtedness.
Medical Expense Deduction – Threshold Temporarily Reduced
For tax years beginning after December 31, 2017 and ending before January 1, 2019, the threshold for the medical expense deduction is reduced to 7.5% for all taxpayers.
Charitable Contribution Deduction Limitation Increased
For contributions made in tax years after December 31, 2017, the 50% limitation for cash contributions to public charities and certain private foundations is increased to 60% of your adjusted gross income. Contributions exceeding this 60% limitation are generally allowed to be carried forward and deducted for up to five years, subject to the later year’s ceiling.
No Deductions for Amounts Paid for College Athletics Seating Rights
For contributions made in tax years beginning after December 31, 2017, no charitable deduction is allowed for any payment to an institution of higher education in exchange for which the payer receives a right to purchase tickets or seating at an athletic event.
For any divorce or separation agreement executed after December 31, 2018 or executed before that date but modified after it (if the modifications expressly provide that the new amendments apply), alimony and separate maintenance payments are not deductible by the payor spouse and are not included in the income of the payee spouse.
Miscellaneous Itemized Deductions Suspended
For tax years beginning after December 31, 2017, the deduction for miscellaneous itemized deductions that are subject to the 2% floor is suspended.
Moving Expenses Deductions Suspended
For tax years beginning after December 31, 2017, the deduction for moving expenses is suspended except for members of the armed forces on active duty who move pursuant to military order and incident to a permanent change of station.
Repeal of Obamacare Individual Mandate
Under pre-Act law, the Affordable Care Act required that individuals who are not covered by a health plan that provided at least minimum essential coverage were required to pay a “shared responsibility payment” (also referred to as a penalty) with their federal tax return. For months beginning after December 31, 2018, the amount of the individuals share responsibility payment is reduced to zero. The repeal is permanent.
Alternative Minimum Tax (AMT) Retained with Higher Exemption Amounts
For tax years beginning after December 31, 2017, the AMT exemption amounts for individuals are increased.
Student Loan Discharge on Death or Disability
For discharges of indebtedness after December 31, 2017, certain student loans that are discharged because death or total disability of a student are also excluded from gross income.
Estate and Gift Tax Retained, with Increase Exemption Amounts
For estates of decedents and gifts made after December 31, 2017, JCTA doubles the base estate and gift tax exemption amount from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011 and is expected to be approximately $11.2 million in 2018. As such, a married couple can shelter about $22.4 million dollars.
Business Tax Changes
Corporate Tax Rates Reduced
For tax years beginning after December 31, 2017, the Corporate tax rate is a flat 21% rate.
Dividends Received Deduction Percentages Reduced
For tax years beginning after December 31, 2017, the 80% dividends received deduction is reduced to 65% and the 70% dividends received deduction is reduced to 50%.
Alternative Minimum Tax Repeal
For tax years beginning after December 31, 2017, the Corporate AMT is repealed. For tax years beginning after 2017, the AMT credit is refundable and can offset regular tax liability in an amount equal to 50% of the excess minimum tax credit for the tax year over the amount of the credit allowance for the year against regular tax liability. Accordingly, the full amount of the minimum tax credit will be allowed.
Increased Code Section 179 Expense
For property placed in service in tax years beginning after December 31, 2017, the maximum amount a taxpayer may expense under Code Section 179 is increased to $1 million. The phase out threshold amount is increased to $2.5 million. These amounts will be indexed for inflation after 2018.
The definition of (Code §179) qualified real property is expanded to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. The definition for qualified real property eligible for Section 179 expensing is also expanded to include the following improvements to non-residential real property after the date the property was first placed in service: roofs; heating, ventilation, air conditioning property; fire protection and alarm systems; and security systems.
Temporary 100% Cost Recovery of Qualifying Business Asset
A 100% first year deduction for the adjusted basis is allowed for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Thus, the phase down of the 50% allowance for property placed in service after December 31, 2017 is repealed. The additional first year depreciation deduction is allowed for new and used property. (The bonus depreciation should not be confused with expensing under Code Section 179 which is subject to entirely separate rules).
In later years the first-year bonus depreciation deduction phases out as follows:
- 80% for property placed in service after December 31, 2022 and before January 1, 2024.
- 60% for property placed in service after December 31, 2023 and before January 1, 2025.
- 40% for property placed in service after December 31, 2024 and before January 1, 2026.
- 20% for property placed in service after December 31, 2025 and before January 1, 2027.
- First year bonus depreciation sunsets after 2026.
Luxury Automobile Depreciation Limits Increase
For passenger automobiles placed in service after December 31, 2017, and tax years ending after that date, for which additional first year depreciation (Bonus Depreciation) is not claimed, the maximum amount of allowed depreciation is increased to $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. For passenger automobiles placed in service after 2018, these dollar amounts will be indexed for inflation. For passenger automobiles eligible for bonus-first year depreciation, the increase to the first year depreciation limit remains $8,000.
In addition, computer or peripheral equipment is removed from the definition of listed property and therefore is not subject to the heightened substantiation requirements that applies to listed property.
New Farm Equipment and Machinery as Five-Year Property
For property placed in service after December 31, 2017, and tax years ending after that date, the cost recovery period is shortened from 7 to 5 years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer.
In addition, the required 150% declining balance depreciation method for property used in a farming business, (i.e., for 3, 5, 7 and 10-year property) is repealed. The 150% declining method continues to apply for any 15 or 20-year property used in farming business to which straight-line method does not apply and to property for which the taxpayer elects the use of the 150% declining balance.
Recovery Period for Real Property Shortened
For property placed in service after December 31, 2017, the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property are eliminated, a general 15-year recovery period and straight-line depreciation are provided for qualified improvement property and a 20-year ADS recovery period is provided for such property.
Thus, qualified improvement property placed in service after December 31, 2017, is generally depreciable over 15 years using the straight-line method and half-year convention, without regard to whether the improvements are property subject to a lease, placed in service more than 3 years after the building was first placed in service, or made to a restaurant building.
For property placed in service after December 31, 2017, the ADS recovery period for residential rental property is shortened from 40 years to 30 years.
Limits on Deductions of Business Interest
For tax years beginning after December 31, 2017, every business, regardless of its form, is generally subject to disallowance of deduction for net interest expense in excess of 30% of the business’ adjusted taxable income. The net interest expense disallowance is determined at the tax-filer level. However, a special rule applies for pass-through entities, which requires the determination to be made at the entity level, for example, at the partnership level instead of the partner level. For tax years after December 31, 2017, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion. Taxpayers who have average annual gross receipts for the prior 3 years of less than $25 million are exempt from the interest deduction limitation.
Real property trades or business and farming businesses can elect out of this provision if they use ADS to depreciate the property used in the business. There is also an exception from the limitation on business interest deduction for businesses for floor plan financing (i.e., financing for acquisition motor vehicles, boats or farm machinery for sale or lease and secured by such inventory).
Modifications of Net Operating Loss Deduction
For net operating losses arising in tax years ending after December 31, 2017, the two-year carryback and the special carryback provisions are repealed. However, a two-year carryback applies in the case of certain losses incurred in a trade or business of farming. For losses arising in tax years beginning after December 31, 2017, the NOL deduction is limited to 80% of taxable income. Carryovers to other years are adjusted to take account of this limitation.
Domestic Production Activities Deduction Repealed
For tax years beginning after December 31, 2017, the domestic production activities deduction (DPAD) is repealed for non-corporate taxpayers. For tax years beginning after December 31, 2018, the DPAD is repealed for C-Corporations.
Like-Kind Exchange Treatment Limited
Generally effective for transfers after December 31, 2017, the rule allowing for deferral of gain on like-kind exchanges is modified to allow for like-kind exchanges only with respect to real property that is not held primarily for sale.
Employers Deduction for Fringe Benefit Expense Limited (Including Meals and Entertainment)
For amounts incurred or paid after December 31, 2017, deductions for entertainment expenses are disallowed. The current 50% limit on deductibility of business meals is expanded to meals provided through an in-house cafeteria or otherwise on the premises of the employer. Deductions for employee transportation fringe benefits (e.g., parking and mass transit) are denied. However, the exclusion from income for such benefits received by the employee is retained. In addition, no deduction is allowed for transportation expenses or equivalent of commuting for the employee (e.g., between the employee’s home and the workplace), except for as provided for the safety of the employee.
New Credit for Employer Paid Family and Medical Leave
For wages paid in tax years beginning after December 31, 2017, but not beginning after December 31, 2019, the Act allows businesses to claim a general business credit equal 12.5% of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave (FMLA), if the rate of payment is 50% of the wages normally paid for the employee. The credit is increased by 0.25 percentage points (but not above 25%) for each percentage point of which the rate of payment exceeds 50%. All qualifying full-time employees must be given at least two weeks of annual paid family and medical leave (all less than full-time qualifying employees must be given a commensurate amount of leave on a pro rata basis).
Accounting Method Changes
For tax years beginning after December 31, 2017, an accrual method taxpayer is generally required to recognize income no later than the tax year in which such income is taken into account on an Applicable
Financial Statement (AFS) or other financial statement under rules specified by the IRS. This rule is subject to an exception for long-term contract income under Internal Revenue Code Section 460. If an accounting method change is needed to conform to this new rule, such change will be treated as initiated by the taxpayer and made with the IRS’s consent.
Cash Method of Accounting
For tax years beginning after December 31, 2017, the cash method may be used by taxpayers that satisfy a $25 million gross receipts test, regardless of whether the purchase, production, or sale of the merchandise is an income producing factor. Under the gross receipts test, a taxpayer with average annual gross receipts that did not exceed $25 million for the three prior tax years can use the cash method. The exception from the required use of the accrual method for qualified personal service corporations and taxpayers other than C-Corporations is retained. Accordingly, qualified personal service corporations, partnerships without C-Corporation partners, S-Corporations and other pass-through entities can use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the method clearly reflects income.
Accounting for Inventories
For tax years beginning after December 31, 2017, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Code Section 471 but rather may use an accounting method for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.
Accounting for Long Term Contracts
Generally, construction companies with average annual gross receipts of $10 million or less in the prior 3 years are exempt from the percentage of completion method. The TCJA expands this exemption to contracts for the construction or improvement of real property if the contract (1) is expected to be completed within 2 years and (2) is performed by a taxpayer that meets the $25 million gross receipts test discussed earlier. This change is effective for contracts entered into after December 31, 2017.
Exclusions From Contributions to Capital
Current Revenue Code Section 118 excludes contributions to the capital of a corporation from the corporation’s gross income. The TCJA provides that the term contributions to capital does not include (1) any contribution in aid of construction or any other contribution as a customer or potential customer and (2) any contribution by any governmental entity or civic group (other than a contribution by a shareholder as such).
New Deduction for Pass-Through Entities
Generally, for tax years beginning after December 31, 2017 the TCJA adds a new code section 199 (A), “Qualified Business Income” under which a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S-Corporation or sole-proprietorship is allowed a deduction of 20% of the QBI. “QBI” from a partnership, S-Corporation, sole-proprietorship is defined as the net amount of items of income, gain, deductions and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income.
The 20% deduction is taken “below the line”, i.e. it reduces your taxable income but not your adjusted gross income. It is available regardless of whether you itemize or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gains. If QBI is less than zero, it is treated as a loss from a qualified business in the following year.
For taxpayers with taxable income above $157,000 ($315,000 for joint filers) an exclusion from QBI income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is a reputation or skill of one or more employees or owners. Here is how the phase-in works:
If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 plus $50,000), all the net income of a specified trade or business is excluded from QBI (joint filers will use an amount $100,000 above the $315,000 threshold, (viz., $415,000). If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess taxable income over $157,500 and the denominator of which is $50,000. So, e.g., if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000 divided by $50,000). For joint filers, the same operation would apply using the $315,000 threshold and a $100,000 phase out range.
Additionally, for taxpayers with taxable income more than the above threshold, the limitation on the amount of the deduction is phased in based on wages paid or wages paid plus a capital element. Here is how it works:
If your taxable income is at least $50,000 above the threshold, i.e. $207,500 ($157,500 plus $50,000), the deduction for QBI cannot exceed the greater of (1) 50% of the taxpayer’s allowed share of W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible personal property used in the business, including real estate. So, if your QBI is $100,000, leading to a deduction of $20,000 (20% of $100,000) but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. If your taxable income is between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with a percentage worked out via the fraction discussed in the preceding paragraph (for joint filers, the same operation by using the $315,000 threshold and $100,00 phase out range).
Retirement Plan Provisions
Repeal of the Rule on Re-Characterization of IRA Contributions
For tax years beginning after December 31, 2017, the rule that allows a contribution of one type of IRA to be re-characterized as a contribution to the other type IRA does apply to a conversion contribution to a Roth IRA. Thus, re-characterization cannot be used to unwind a Roth conversion.
As you can see, the TCJA is going to bring a lot of change to individual and business taxpayers. In this letter, we have simply tried to highlight some of the changes that were made that may affect you. Many of these changes are very complex. With the changes that have been made, you should have your Will and Estate Plan reviewed and make sure it takes advantage of the changes made in the Tax Act and accomplishes your goals. In addition, if you are over 65 or retired due to permanent and total disability, you should apply for your Alabama State Property Tax Exemption on your residence. You may also qualify for County Property Tax Exemption based on income. Should you have questions regarding any of these changes and how they may affect you, please contact us and we will be more than happy to navigate you through the planning.