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KSM Blog | Katz, Sapper & Miller CPA

Tax Reform and Long-Term Planning: Top Tips for Individuals and Businesses

Posted 3:58 PM by

As Congress continues to push tax reform forward, it seems almost inevitable that widespread changes to the federal tax code will occur. These changes will not only require businesses and individuals to consider immediate year-end tax planning strategies, they also will require new considerations when planning for the future. Some of the most important items to consider include:

1. Estate Planning

Under current law, every person has an inflation-adjusted $5 million gift/estate tax exemption and an inflation-adjusted $5 million generation-skipping transfer (GST) tax exemption. Under both the House and the Senate tax bills, the gift/estate tax exemption and the GST tax exemption would increase to $10 million (with inflation adjustments) beginning in 2018.

However, there are significant differences in the bills. Under the Senate bill, the $10 million gift/estate tax exemption and GST tax exemption will only stay in effect until 2026, at which point the gift/estate tax exemption and GST tax exemption would return to $5 million (with inflation adjustments). In contrast, under the House bill, the estate tax and GST tax would be completely repealed after 2024. After repeal, property in an estate would still be eligible for a stepped-up basis at death. The House bill also provides that the gift tax rate would decrease from 40 percent to 35 percent for gifts made after 2024.

For long-term planning, starting in 2018 taxpayers should consider using the increase in the gift/estate tax exemption and GST tax exemption from $5 million to $10 million. This means that an additional $5 million could be gifted free of tax.

2. Choice of Business Entity

Under the current tax system, C corporations are taxed on a tiered system ranging between 15 percent and 39 percent and are subject to an alternative minimum tax (AMT). Personal service C corporations are taxed at a flat rate of 35 percent. Pass-through entities (i.e., partnerships, S corporations, and LLCs) are not taxed at the entity level but are taxed at the individual owner’s ordinary income rates ranging between 10 percent and 39.6 percent. Both the House and Senate bills provide sweeping changes to the way that business entities are taxed.

Under both the House and the Senate tax bills, the tax rate on all C corporations will be reduced to a flat 20 percent. The House bill would also repeal the AMT for C corporations, while the Senate bill would retain the AMT. The tax treatment of pass-through entities varies greatly between the two bills and is substantially more complicated than the straightforward C corporation treatment.

Under the House bill, the portion of an individual’s pass-through income that qualifies as “business income" would be taxed at a maximum rate of 25 percent, while the remaining pass-through income would continue to be taxed at the individual’s ordinary income rates. The “business income,” which qualifies for the reduced rate, consists of all of the individual’s passive pass-through income and the “capital percentage” of the individual’s non-passive pass-through income. The “capital percentage” is set at a default rate of 30 percent, except for personal service businesses, which have a default rate of zero percent. An individual may elect to use a formula based on the pass-through entities’ deemed return on capital investments to determine an alternative percentage. Under this method, a personal service business would need to achieve a percentage of at least 10 percent to qualify for the reduced tax rate.

Under the Senate bill, individual owners of pass-through entities would be eligible for a deduction for the lesser of 23 percent of their pass-through income or 50 percent of the W-2 wages paid by the pass-through entities. At this point it is unclear whether the 50 percent limitation on W-2 wages applies on a legal entity-by-entity basis or if it applies to all of the individual’s aggregated trade or business activities treated as a single trade or business. If a taxpayer filing returns as married filing jointly has taxable income of $500,000 or less ($250,000 or less for individuals), then the 50 percent of W-2 wages limitation will not apply. Instead, these taxpayers would receive the deduction for 23 percent of their pass-through income.

For long-term planning, these new tax provisions will likely have a dramatic effect on a taxpayer in several ways. When a taxpayer is forming a new entity or determining whether to change an existing entity, the taxpayer must take into consideration whether the preferential tax rates for C corporations offsets the benefits for pass-through entities. The tax benefit to C corporations would be further increased if the House bill provision repealing the AMT for C corporations were to pass as well. Other considerations include the need for a taxpayer to retain capital in the business and the expected timing and exit strategy from a business.

For taxpayers with pass-through entities, the bills also provide long-term planning considerations. If the House bill is passed, it would be advantageous for taxpayers to be passive in their pass-through activities because 100 percent of passive pass-through income would be taxed at the preferential tax rate. If the Senate bill is passed, taxpayers will need to consider restructuring the compensation and allocation of employee wages through their pass-through entities in order to capitalize on the deduction limitation of 50 percent of employee wages.

3. Research and Experimentation Expenditures

Under the current tax system, research and experimentation expenses are deductible expenses in the year they are incurred. Additionally, research and experimentation expenses which are considered “qualified” are eligible for the research expense credit.

Under both the House and the Senate bills, research and experimentation expenses will no longer be deducible in the year they are incurred. Instead, the expenses must be amortized over a five-year period or, if the research is conducted outside the United States, over a 15-year period. The bills differ, however, as to when this amortization requirement becomes effective. Under the House bill, this amortization provision applies to research and experimentation expenses incurred after Dec. 31, 2022. Under the Senate bill, this amortization provision applies to research and experimentation expenses incurred after Dec. 31, 2025.

For taxpayers who engage in occasional research and experimentation activities, this new provision incentivizes the completion of any pending research and experimentation prior to the effective date in 2023 or 2026.This provision also makes it critical to identify which expenses would be treated as research and experimentation expenses as opposed to another fully deductible expense. For taxpayers who regularly engage in research and experimentation, this provision cannot be avoided following the effective date. However, the amortization provision does place a premium on claiming the research expense credit in the year the expenses were incurred. The research expense credit was retained in both the House and the Senate version of the tax bill. Although the research expense credit will not allow a taxpayer to deduct the research and experimentation credits in the year incurred, it will maximize the benefit to the taxpayer for its performance of research and experimentation activities.

4. Employee Business Expense

Under the current law, unreimbursed business expenses incurred by an employee are deductible to the employee as a miscellaneous itemized deduction subject to the two percent floor. However, this deduction would be eliminated under both the House and Senate’s tax bill.

Under the House bill, the deduction for unreimbursed business expenses incurred by an employee would be denied. However, the House bill would preserve the above-the-line deduction for reimbursed business expenses incurred by an employee and included in the employee’s income. Under the Senate bill, all itemized deductions subject to the two percent floor, including unreimbursed business expenses incurred by an employee, would be denied. The Senate bill does not address the provision for the above-the-line deduction for reimbursed business expenses.

With both bills repealing the deduction for unreimbursed business expenses incurred by an employee but retaining the above-the-line deduction for reimbursed business expenses included in an employee’s income, employers should consider updating their policies for employee business expenses. Employers who previously did not reimburse an employee for business expenses incurred in the course of their employment, may now want to adjust their policies to allow for reimbursement of these expenses. For example, if employees previously were not reimbursed for travel expenses, an employer may now want to consider reimbursing employees travel expenses on a per-mile basis.

5. Business Interest Expense Deduction

Under the current tax system, businesses are allowed to deduct all interest on indebtedness paid or accrued during a tax year. This deduction is limited in certain situations. However, this deduction would be significantly limited under both the House and the Senate bill.

Under the House bill, the interest expense deduction is limited to 30 percent of the business’ adjusted taxable income. Businesses with average annual gross receipts of $25 million or less are exempt from this limitation under the House bill. The Senate’s bill also limits a business’ interest expense deduction, but allows a maximum deduction of interest expense equal to the sum of 30 percent of the business’ adjusted taxable income, the business’ interest income for the year, and the floor plan financing interest. Under the Senate bill, businesses with average annual gross receipts of $15 million or less are exempt from this limitation, and businesses are allowed to carry forward previously disallowed interest deduction indefinitely.

The new limitation on the amount of deductible business interest expense means that businesses, specifically pass-through entities, should consider the impact of restructuring using preferred equity as opposed to debt.

For questions on how these long-term considerations may apply to you, please contact your KSM advisor. Continue to check our blog for a full breakdown of the relevant tax provisions once a tax bill is signed into law.

About the Author
Rosanne Ammirati is a partner in Katz, Sapper & Miller’s Tax Services Group. Rosanne provides expertise on tax research and tax planning for business entities, individuals, estates, and trusts.

 

About the Author
Alex Szarenski is a manager in Katz, Sapper & Miller's Tax Services Group. Alex's focus includes analytical research and planning services to a diverse clientele in numerous industries. Connect with him on LinkedIn.

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