By Bryan Freschcorn, Tax Manager
It’s important to remember that this framework is proposed — any tax reform legislation that is passed by Congress will likely look very different in its final form. We will continue to monitor changes and keep you informed.
As the end of the year approaches, Congress is scrambling to pass a tax bill. This week, the U.S. House of Representatives plans to vote on and pass H.R. 1 – the “Tax Cuts and Jobs Act.” Meanwhile, the Senate Finance Committee has introduced its version of the tax bill, hoping to schedule a full vote by the Senate sometime around November 30.
Unfortunately, the late introduction of the Act and the very tight deadline for passage will result in frenetic activity and a final bill that may be nothing like the Act, particularly now that the Senate has introduced another attempt to partially repeal the Affordable Care Act. Rather than getting too bogged down with information that will significantly change, we did want to bring attention to specific provisions that have not been widely brought to the public’s attention. Differences in the Senate proposal are in bold. Taxpayers with international operations are beyond the scope of this discussion.
As anticipated, federal income tax rates would be reduced for corporations and most individuals.
- Corporations would pay a flat 20% rate. The current rate of 15% for taxable income of $50,000 or less goes away. The Senate would delay the cut until 2019.The Senate’s bill, as currently structured due to deficit rules, would require 60 “aye” votes and would undoubtedly fail to pass.
- The number of individual tax rates, currently seven, range from 10% to 39.6%. The Act reduces the rates to four brackets, ranging from 12% to 39.6%. For those with low incomes, some may be facing a slight income tax increase. The marriage penalty begins at a higher taxable income level for joint filers — $90,001 as proposed vs. $75,901 for 2017. The Senate maintains seven brackets, but the top rate drops to 35%, revised from an original proposal of 38.5%. It will pay for that drop by repealing the mandate for health insurance, reducing subsidies.
- Capital gains and dividend income rates are unchanged. As you probably have already read, carried interest will continue to be taxed at capital gains rates, but with a requirement that the related assets be held for three years to qualify for long-term treatment.
- The alternative minimum tax (AMT) would be repealed for both corporations and individuals. For taxpayers with AMT credit carryovers, 50% of the remaining credit from the prior year can be claimed in 2019 to 2021, and the remainder in its entirety in 2022. Assuming a $10K carryover, $5K could be applied against 2018 taxes, $2.5K in 2019, $1.25K in 2020, $0.625K in 2021, and the balance in 2022. The repeal of AMT appears to be a certainty.
- The net investment income tax of 3.8% remains as does the kiddie tax.
- The standard CPI-U will be used to adjust various brackets and exemption amounts. Beginning in 2023, the alternative chained CPI-U, which is lower because it emphasizes substitution when inflation increases, will replace the traditional CPI-U.
- Because the CPI-U is also used to calculate increases in government benefits, the chained CPI-U would result in a decrease in Social Security benefits, beginning in 2023. Increases in allowable IRA, HSA, and 401(k) contributions would also decrease.
Inventory/Basis of Tax Accounting
The Act expands the ability of businesses to use the cash method of tax accounting, permitting the use of the cash method if average annual gross receipts for the prior three years are less than $25 million. For businesses with inventory that currently have to use the accrual method, the Act will also allow cash basis if receipts do not exceed the $25 million threshold. The Senate reduces the threshold to $15 million.
Taxation of Pass-Through Income
“Pass-throughs” are business entities taxed at the owner or shareholder level. These include S-corporations, partnerships, and sole proprietorships. When combined with the shareholder’s/owner’s other income, the marginal income tax incurred from the pass-through operations could exceed the tax paid if the pass-through had instead been taxed as a C-corporation.
The Act addresses this perceived tax inequity by introducing a new pass-through tax rate of 25%, applied to what is termed “qualified business income” or QBI.
However, this rate does not apply to “specified service activities” or SSA. This includes “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, 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 one or more of its employees” as defined in Section 1202(e)(3)(A) of the Internal Revenue Service Code.
The calculation of pass-through income will be complicated. For non-SSA businesses, the default supposition is that 70% of pass-through will come from the owner’s labor, thus subject to the applicable individual tax rate (as high as 39.6). The other 30% is presumed to come from capital, taxed at 25%.
The non-SSA business can use an allocation shifting part of that labor split to capital, based on a particular formula outlined in the Act. Essentially, the more property and equipment a company has, the higher the allocation to capital.
For SSA businesses, the presumption is that all the QBI comes from labor, subject to 39.6%. While the 100% allocation from labor can be reduced using the allocation calculation, SSA business owners feel that this 100% default allocation is unfair.
It appears likely that the pass-through proposal will have to be modified because the potential for creative accounting seems to be high.
The Senate plan is much more straightforward, allowing a 17.4% deduction for passthrough income but the deduction does not apply to specialized service businesses. The deduction is also limited to 50% of the taxpayer’s wages from either a related S-corporation or other employers of the taxpayers.
Property and Equipment
The Act increases the opportunity to write off new equipment purchases.
- “Bonus depreciation” currently permits businesses to write off 50% of its equipment purchases, presuming the equipment is new. As proposed, companies will be able to write off 100% of equipment purchases purchased after September 27, 2017, through the end of 2023. The equipment does not have to be first-use equipment; it can be used or refurbished. The Senate makes bonus depreciation permanent.
- One big caveat – any property used in a “real property trade or business” is not eligible as defined in section 469(c)(7)(C) or “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”. It appears, then, that the desks and computers of an apartment management company would not be eligible for bonus depreciation.
- Whatever the rationale of Congress, potential immediate write-off of eligible property via Section 179 is still available for that management company as the Act increases the possible write-off to $5 million from $510,000. The dollar-for-dollar phaseout does not start until the cost of eligible Section 179 property is over $20 million (currently $2 million). The Senate increases the Section 179 limit to $1 million with the phase-out starting at $2,500,000. Section 179 property would include roofing and HVAC. Limitations for SUVs/luxury autos remain. The Senate shortens the depreciable period for real rental property and restaurant buildings to 25 years. Qualified improvement property will be depreciable over ten years rather than the current 15 years.
- Like-kind (Section 1031) exchanges of real property were considered to be in danger, but the deferral of gains are still available for future years. Like-kind exchanges of personal property, such as the trade-in of a truck, however, will be taxable as will be the exchanges of collectibles and art.
- For businesses regardless of form (corporations, self-employed, pass-throughs), the proposed deduction for interest expense would be limited to 30% of adjusted taxable income (earnings before interest expense, interest income, federal income taxes, net operating losses, depreciation, amortization, and depletion). Interest not currently deductible can be carried over. This limitation does not apply to businesses with average gross receipts of $25 million or less for all prior tax years. Car dealerships would be exempt. Again, the Senate reduces the threshold to $15 million. The Senate ‘s definition of adjusted taxable income is earnings before interest expense and taxes. Depreciation, amortization, and depletion are not added back, resulting in deductible interest being reduced even further. No language regarding dealerships.
- For individuals, interest deductibility for new home mortgages will be limited to $500,000 of acquisition indebtedness (the amount borrowed to acquire or improve property). Interest is deductible for only the principal residence. Thus interest expense for new second-home loans will not be deductible. You cannot deduct the interest on new home equity loans. You will be able to refinance existing debt and deduct all the interest, provided there is no cash-out. “New” means after November 2, 2017.That date is likely to be changed. The Senate increases the limit to the first $1 million.
- Investment interest expense for individuals will continue to be deductible, subject to current limitations.
With lower tax rates, the drafters of the Act argue that fewer itemized deductions should be permitted. With that in mind,
- Medical expenses, including health insurance, are no longer deductible. Because the current law only allows a deduction for costs exceeding 10% of adjusted gross income, we do not see this very often for our younger clients. For our older clients, the deduction is relatively common, particularly for those with chronic disease or living in assisted living facilities. The Senate preserves the deduction.
- For those self-employed, health insurance continues to be deductible from total income to calculate adjusted gross income.
- State and local income taxes would no longer be deductible, nor will sales tax in states with no income tax. Up to $10,000 in domestic, not foreign, property taxes remain deductible. After taking the unpopular vehicle personal property tax into consideration, it is not uncommon for property taxes to exceed that in high-cost Northern Virginia. The Senate would eliminate the deduction for all state and local income and sales tax.
- Unreimbursed employee business expenses are no longer deductible. Currently, some salespersons are expected to incur their own sales-related costs which can be considerable. Given the potential loss of after-tax income, there could be blowback, creating a shift to back to employer reimbursement or higher commissions.The Senate eliminates all miscellaneous itemized deductions, including investment and trustee fees.
Younger employees, particularly working parents with student loan debt working downtown, will find many things not to like about the Act.The following are proposed for elimination:
- Student loan interest deduction of up to $2,500.
- Pre-tax dependent care assistance of up to $5,000.
- Pre-tax transportation fringe benefits of up to $255 per employee month for transit (the Metro/busses/Ride Share) and $255 per month per employee for parking.
- Employer-paid relocation expenses will become taxable,
These provisions hit doubly-hard those employees paying back their federal student loans under income-based repayment plans.Because the eliminations would increase the borrowers’ adjusted gross income,their required payments would increase as well. Not counting relocation, a married couple in Arlington commuting via the Metro to DC could be looking at as much as $13,620 in additional adjusted gross income.The increase would result in extra loan payments of as much as $2,000 annually, not to mention the additional income and payroll taxes.
- While qualified meal expenses are still 50% deductible, entertainment expenses will no longer be deductible at all. Combined with municipal interest on debt incurred for new professional team stadiums now being taxable, the search for a new venue for the Redskins might become more difficult.
- Churches and religious organizations will be free to engage in political activity. According to Congress’ Joint Committee on Taxation, political contributions are anticipated to be funneled through churches and become fully deductible.
- Many colleges allow faculty children to attend at discounted tuition rates and have reciprocal agreements with other schools. Discounted tuition will become taxable.
State Income Taxes
Overlooked or perhaps not, the Act would likely result in additional state corporate and individual income taxes. Most states’ income tax calculations start with federal taxable income and then add or subtract various state adjustments. Many, if not most states, including Virginia, do not permit bonus depreciation and do not allow the full level of Section 179 depreciation. That frequently results in an add-back of depreciation, causing state taxable income to increase.
Unlike the federal government, states cannot incur deficits. The Act, in whatever its final form, is likely to bring about reduced payments to the states, increasing their budget pressures. Consequently, state income tax rates may not change. With a broader taxable income base, total state tax revenues will increase relatively if not absolutely.
For 2018, the outlook is unsettled. There are many proposed changes to tax law, particularly for pass-through areas, but as we said earlier, the final bill will be much different. In any case, as we say every year, and even more critical now, be sure to consult your tax advisor before making any potentially significant moves that might affect your taxes.
We will continue to monitor changes and keep you informed.
Additional Resources on this topic:
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.