What Tax Reform Means for Family Offices
The structure and dynamics of family offices are often as varied as families themselves. Because of that, the new tax law will impact each family office differently. While there are a number of new tax provisions that should be considered, the following is a summary of the ones that are most likely to impact you and your family:
For many family offices, the impact of the new tax law will include how it impacts individuals themselves. While the new tax law retains seven tax brackets, the tax rate for those in the highest bracket (over $500,000 adjusted gross income) has dropped to 37 percent from 39.6 percent. This is good news for most high-net-worth individuals, as they often fall into this bracket. However, the new tax law also imposes some limitations on deductions, which will impact tax liability. Here is a list of four of the law’s provisions that will affect high-net-worth individuals:
- Miscellaneous Itemized Deductions: The new tax law suspends all miscellaneous itemized deductions subject to the two percent floor. This would include investment and asset management fees. In the past, these were deductible subject to limitations; now they will no longer be deductible at all. However, for family offices that are set up as a trade or business – instead of an investment activity – it is possible that these would still be deductible.
- Mortgage Interest Deduction: Under the new tax law, the mortgage interest deduction limitation will be reduced to $750,000 from the previous limitation of $1 million. For any debt incurred prior to Dec. 15, 2017, the limitation will remain at $1 million. This deduction only applies to home acquisition indebtedness for a principal residence and one other residence. Mortgage interest paid on home equity indebtedness is no longer deductible unless it is used to buy, build, or substantially improve the taxpayer’s home. The IRS considers such a loan to be home acquisition indebtedness, regardless of how a lender classifies the loan.
- State and Local Tax Deduction: The new tax law imposes a limitation on the deduction of sales tax, income tax, or property taxes, capping it at $10,000. For people with multiple homes and high state and local tax payments, this limitation will be keenly felt. Some states, including California, New Jersey, and New York, are proposing new legislation at the state level to address the capping of this deduction.
- Charitable Contributions: The adjusted gross income limitation on cash contributions made to qualifying charities is increasing to 60 percent under the new law, up from the previous limitation of 50 percent. Additionally, any contributions made to a university for seating rights at athletic events will no longer be deductible. Under the previous system, 80 percent of seating right payments made to a university were deductible. The new law raises the limitation, making more of the donors’ gifts deductible in one tax year, assuming they itemize; however, this limitation is only relevant in years where contributions are high relative to overall income.
For more on key provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) and its impact on individuals, visit here.
Estates, Gifts, and Trusts
Family offices and high-net-worth individuals have always been very cognizant of the estate and gift taxation rules. Although the TCJA did not eliminate the estate tax as some had hoped it would, it did raise the exemption amount, allowing families to implement additional wealth transfer to future generations.
- Estate and Gift Taxes: Under the new tax law, the gift tax, estate tax, and generation-skipping transfer tax exemption will increase from $5 million (with inflation adjustments) to $10 million (with inflation adjustments). In 2018, the exemption with inflation adjustments is expected to be $11.2 million. The new tax law has no provision to repeal the estate tax or generation-skipping tax in the future; instead, the exemptions will expire at the end of 2025. The change to the estate and gift tax exemptions creates significant tax planning opportunities for high-net-worth individuals and family offices, and estate plans should be reviewed in light of these changes.
- Trust and Estate Income Tax: Like individuals, trusts and estates will generally be limited to a $10,000 state and local tax deduction starting in 2018 and will no longer be able to deduct investment fees. Those receiving income from trusts and estates would be wise to evaluate the impact of this change prior to filing their 2018 returns.
Entity structure has become a much-discussed issue given that the new tax law provides additional deductions for pass-through entities and reduces the C corporation income tax rate. This details some of the changes impacting pass-through entities, but family offices should discuss and evaluate their own entity structure in light of the entire TCJA to determine the most beneficial structure.
- General Rule: Under previous tax law, income from pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) was taxed as ordinary income to individual owners. Under the new tax law, owners are allowed to deduct 20 percent of “qualified business income” from pass-through entities on their individual income tax return. Under this provision, qualified business income (QBI) is defined as domestic income from a pass-through entity, but it does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments.
In general, the pass-through deduction is 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 those who are married filing jointly or $157,500 for single filers.
The theory of the deduction is that an owner of a sole proprietorship, partnership, limited liability company, or S corporation will benefit from a 20 percent haircut on the taxability of each of their businesses’ QBI and will thus retain the approximate 10 percent tax rate advantage from before the TCJA, compared to a C corporation that pays dividends to its shareholders (generally triggering a second level of taxation).
- Specified Service Trade or 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 trades 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 those who are 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 new tax law disallows excess business losses in a taxable year. However, the excess business losses can be carried forward under the net operating loss provision. To determine the “excess business loss” under the new law, 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 those who are married filing jointly or $250,000 for single filers, and these amounts are indexed for inflation.
The new tax law contains many other changes and provisions that could impact you and your family office, including families that do direct transactions and those who have international income. In order to assess the impact for your specific situation, please contact KSM to discuss tax planning and strategies.
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