Tax Reform Is Here: Key Provisions Explained
In the most sweeping overhaul of the U.S. tax code in more than three decades, the tax reform bill has now been passed by both houses of Congress and is expected to be signed into law by President Trump in the coming days. These significant changes will require businesses and individuals to reassess their long-term tax strategies beginning with the 2018 tax year as well as consider immediate year-end tax planning strategies for the few remaining days of 2017. Below is a rundown of some of the key provisions in the final bill:
Individual Tax Rates
- New Individual Tax Brackets: The new tax bill retains seven tax brackets but lowers the tax rate in the majority of brackets including lowering the maximum tax rate from 39.6 percent to 37 percent.
- Individual Alternative Minimum Tax (AMT): Under the new tax bill AMT for individuals is retained, but the AMT exemption amount for individuals is increased to $109,400 for married filing jointly filers and $70,300 for single filers. Additionally, the new bill will increase the exemption phase-out amounts to $1,000,000 for married filing jointly filers and $500,000 for single filers.
Individual Tax Credits
- Earned Income Tax Credit: The earned income tax credit will be retained under the new tax bill.
- Child Tax Credit: The new bill will increase the child tax credit from $1,000, under the current system, to $2,000. The credit will continue to apply to qualifying children under the age of 17 but will increase the phase-out threshold of the credit to $400,000 for married filing jointly filers (up from $110,000 under current law).
Individual Exemptions and Deductions
- Personal Exemptions: Under the new tax bill personal exemptions will be eliminated beginning in 2018.
- Standard Deduction: The standard deduction will increase from $12,700 to $24,000 for married filing jointly filers and from $6,350 to $12,000 for single filers under the new tax bill.
- Itemized Deduction Limitation: Under the current law, itemized deductions are limited once a taxpayer’s adjusted gross income reaches $313,800 for married filing jointly filers or $261,500 for single filers. The bill will suspend these limitations.
- Miscellaneous Itemized Deductions: The bill will suspend all miscellaneous itemized deductions subject to the two percent floor. Examples of miscellaneous itemized deductions include tax preparation fees, unreimbursed employee expenses, and investment expenses. Additionally, the bill retains the $250 above-the-line deduction for teacher expenses.
- Medical Expense Deduction: Under the new tax bill the medical expense deduction floor will be reduced to 7.5 percent of adjusted gross income from the current floor of 10 percent of adjusted gross income for expenses incurred in 2018 and 2019.
- Mortgage Interest Deduction: The mortgage interest deductions limitation will be reduced to $750,000 of debt incurred from the current limitation of $1,000,000 under the new tax bill. For any debts incurred prior to Dec. 15, 2017, the limitation will remain at $1,000,000 of debt incurred. This deduction only applies to home acquisition indebtedness. Mortgage interest paid on home equity indebtedness is no longer deductible.
- Exclusion of Gain from Sale of Principal Residence: Under current law, gain resulting from the sale of a principal residence is excludable from a taxpayer’s gross income up to $500,000 for married filing jointly filers and $250,000 for single filers. A “principal residence” is a residence used by the taxpayer as their principal residence in two of the previous five years. Both the House and Senate bills proposed defining a “principal residence” as a residence used by the taxpayer as their principal residence in five of the previous eight years. The bill did not adopt this provision, leaving the “principal residence” definition at two of the previous five years.
- State and Local Tax Deduction: The new tax bill will allow individuals to elect to deduct sales tax, income tax, or property taxes up to $10,000. All tax payments will be deemed to have been paid on the last day of the tax year for which the tax was imposed. This means taxpayers may not prepay taxes owed for 2018 in order to ensure their complete deductibility prior to implementation of this rule in 2018.
- Moving Expense Deduction: Under the new tax bill the deduction and tax-free receipt of reimbursement of moving expenses incurred when starting a new job at least fifty miles farther from the taxpayer’s former residence will be suspended. The bill provides an exception for this provision and will continue to allow the deduction for active duty members of the armed forces who move pursuant to a military order.
- Charitable Contributions: The adjusted gross income limitation on cash contributions made to qualifying charities increased to 60 percent, up from the previous limitation of 50 percent under the bill. Additionally, any contributions made to a university for seating rights at athletic events will no longer be deductible. Under the current system, 80 percent of seating right payments made to a university are deductible.
- Alimony Payments: In general, the new tax bill will eliminate the current above-the-line deduction for alimony payments made by a taxpayer. Additionally, alimony payment recipients would not be required to recognize the alimony payments as income. The provision will be delayed by one year, and, therefore, will not be applicable to payments made prior to Dec. 31, 2018
Estates, Gifts, and Trusts
- Estate and Gift Taxes: Under the new tax bill, the gift tax, estate tax, and generation-skipping transfer tax exemption will be increased from $5 million (with inflation adjustments) to $10 million (with inflation adjustments). In 2018, the exemption with inflation adjustments is expected to be $11 million. Unlike the provisions provided in the House’s version of the bill, there is no provision to repeal the estate tax or generation-skipping tax in the future.
- Trust and Estate Income Tax: Like individuals, starting in 2018, trusts and estates will generally be limited to a $10,000 state and local tax deduction and will no longer be able to deduct investment fees.
- Recharacterization of IRA Contributions: Under current law, payments made to a traditional IRA may be recharacterized as a contribution to a Roth IRA, and recharacterized again as a payment made to a traditional IRA during a tax year. Under the new tax bill, this type of reconversion would be disallowed.
Affordable Care Act
- Individual Mandate: The individual mandate portion of the Affordable Care Act will be repealed under the new tax bill.
- General Rule: Under the current tax law, income from pass-through entities (i.e. sole proprietorships, partnerships, limited liabilities companies, and S corporations) are taxed as ordinary income to individual owners. Under the new tax bill, owners will be allowed to deduct 20 percent of their “qualified business income” from pass-through entities on their individual income tax return. Under this provision, “qualified business income” is defined as domestic income from a pass-through entity but does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments.
In general, the pass-through deduction would be further limited to the greater of:
- 50 percent of the individual’s share of W-2 wages paid by the pass-through entity for its workforce, or
- the sum of 25 percent of the individual’s share of W-2 wages paid by the pass-through entity plus 2.5 percent of the unadjusted basis of all qualified property.
However, an individual taxpayer would be exempt from this W-2 limitation if their taxable income does not exceed $315,000 for married filing jointly filers or $157,500 for single filers.
- Specified Service Business: As a general rule, income resulting from a “specified service trade or business” does not qualify for the deduction for pass-through income. Examples of specified service trade or businesses include businesses engaged in the performance of services in the fields of health, law, accounting, and financial services. If an individual taxpayer’s taxable income does not exceed $315,000 for married filing jointly or $157,500 for single filers, the income the taxpayer earns would still be eligible for the pass-through income deduction.
- Business Loss Limitation: The bill disallows excess business losses in a taxable year. However, the excess business losses can be carried forward under the net operating loss provisions discussed below. To determine the “excess business loss” under the new bill, a taxpayer would determine the excess of aggregate trade or business deductions over the taxpayer’s aggregate gross income or gain plus the taxpayer’s threshold amount. The taxpayer’s “threshold amount” will be $500,000 for married filing jointly filers or $250,000 for single filers, and these amounts are indexed for inflation.
- Corporate Tax Rate: Under the current system, C corporations are taxed based on a tiered system with a top rate of 35 percent. The new tax bill will eliminate the tiered system and replace it with a flat 21 percent income tax for C corporations. Additionally, the new tax bill will not have a special tax rate for personal service corporations.
- Corporate Alternative Minimum Tax: The new tax bill repeals the corporate alternative minimum tax. However, corporations with prior year minimum tax credits will continue be able to carry forward the credit and offset it against the corporation’s regular tax liability.
- Contribution of Capital: Beginning in 2018, contributions of capital to a corporation will be included the corporation’s gross income unless the capital contribution is in exchange for stock. When a contribution is made in exchange for stock, the amount of the contribution made in excess of the fair market value of the stock issued will also be included in the gross income of the corporation.
Sales of Assets
- Like-Kind Exchanges: Like-kind exchanges allow for taxpayers to defer gain on the exchange of assets of similar character. The new tax bill limits the type of property that may be used in a like-kind exchange to real property that is not held primarily for sale. This provision eliminates the ability of a business to defer gain recognition on like-kind exchanges of personal property.
- Basis in Sale of Securities: The new tax bill does not include the provision from the Senate’s bill, which would require a taxpayer to use the first-in-first-out (FIFO) method of determining their basis in securities sold. As a result, taxpayers may continue to use the specific identification method when determining their basis in securities sold.
- Sale of Patents: Under current law, if a patent is sold before its commercial exploitation, the gain on the sale is treated as long-term capital gain. Under the House’s bill, this provision was repealed and the gain on such a sale would be recognized as ordinary income. The new tax bill does not adopt the House bill’s provision, so gain from such a sale will continue to be treated as long-term capital gain.
- Sale of Self-Created Property: Under the new bill, gain from the sale of a self-created patent, invention, model or design, or secret formula would result in ordinary income for the taxpayer who created the property or the taxpayer with a substituted or transferred basis from the creator.
Business Expenses and Deductions
- Bonus Depreciation: Businesses will be entitled to expense 100 percent of the qualified property placed in service after Sept. 27, 2017 and before Jan. 1, 2023. Beginning Jan. 1, 2023, the amount of qualified property a business will be able to expense will decrease 20 percent per year. Most used property will also qualify for this 100 percent write-off.
- Section 179 Expense: Under current law, businesses may deduct up to $500,000 (indexed for inflation) of qualified real property placed in service each year. The bill increases the deduction amount to $1 million per year. Additionally, the bill expands the definition of qualified real property to include all qualified improvement property and certain improvements made to non-residential real property.
- Interest Expense Deduction: Deductions for business interest expenses will be limited to the sum of:
- business interest income,
- 30 percent of the business’s adjusted taxable income,
- interest from the floor plan financing.
Businesses with average annual gross receipts of $25 million or less will be exempt from this limitation and would be able to deduct any interest expenses in full. For this provision, adjusted taxable income is determined without regard to depreciation, amortization, or depletion deductions.
- Domestic Production Activity Deduction: The new tax bill will repeal the deduction for domestic production activities.
- Net Operating Loss Deduction: Under the new tax bill, net operating loss deductions will be limited to 80 percent of a business’s taxable income.
- Entertainment Expenses: Currently a business may deduct 50 percent of expenses incurred for entertainment, amusement, or recreation. The new tax bill would eliminate this deduction, meaning that no amount of these expenses would be deductible by a business. The new tax bill retains the current 50 percent deduction limitation on food and beverage expenses.
- Research and Experimentation Expenses: Under current law, research and experimentation credits are fully deductible in the year they are incurred. The bill requires research and experimentation expenses incurred after Dec. 31, 2021 to be amortized over a five-year period.
- Research and Development Credit: The new tax bill preserves the research and development credit.
- Employer-Provided Child Care Credit: Under the new bill, the employer-provided child care credit is preserved.
- Work Opportunity Credit: The Work Opportunity Credit is preserved under the new tax bill.
- Rehabilitation Credit: The bill will provide a 20 percent rehabilitation credit for qualified rehabilitation expenditures made to historic structures. A taxpayer would claim the credit ratably over a five-year period beginning in the year the structure is placed in service.
For questions on how these tax provisions apply to you, please contact your KSM advisor.
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