MC Legislative Update: Income Tax Provisions of the Tax and Jobs Act
Updated: Jan 27, 2021
December 22, 2017 (Updated March 16, 2018)
H.R. 1: An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 (“Act”) enacted by Congress on December 20, 2017, is the most comprehensive tax reform measure since 1986. President Trump will sign this legislation into law before the end of the year if sixty Senators agree to waive the PayGo rules to avoid imposing its required spending cuts in 2018. If not, the President may defer signing the Act until January. While the Act contains extensive provisions changing income tax law, the summary below is limited to those provisions most relevant to our audience.
To pass this legislation with a majority vote in the Senate instead of the normally required sixty votes, the legislation was enacted as a budget reconciliation measure. The Senate’s “Byrd” rule prohibits legislation enacted under budget reconciliation from adding to the deficit outside of the ten-year budget window and requires that it constrain any increase within that window to the 1.5 trillion dollars permitted by the previously adopted budget resolution. Although the original name of the bill (“Tax Cut and Jobs Act”) was held to violate the Byrd rule and removed, the bill is likely to continue to be referred to by that name.
In order to permit significant changes enacted for corporations to become permanent, including the new 21% income tax rate, it was necessary to provide that virtually all the provisions in the legislation affecting individuals’ sunset or expire after 2025. Virtually all the provisions of the Act affecting individuals, including those which lower tax rates, increase exemptions, and repeal deductions, will expire after 2025. Without further legislation, the tax code in 2026 will look very much like it does today for individual taxpayers. Of course, if the balance of power in Washington shifts, there could be new tax legislation enacted even before 2026.
Maximum Tax Rate
The Act lowers the maximum income tax rate applicable to individuals to 37% beginning in 2018. The maximum rate will become applicable when taxable income exceeds $600,000 on a joint return, $500,000 on the return of a single individual, and $300,000 on the return of a married person filing separately. The maximum tax rate on long-term capital gain income and qualified dividend income will remain at 20% and the 3.8% Medicare tax is also retained. After 2025, the maximum rate will revert to 39.6%.
Charitable contributions. The Act increases the limitation on the deduction of cash contributions to publicly supported charities and private operating foundations from 50% of the taxpayer’s adjusted gross income to 60% beginning in 2018.
State and local taxes. Beginning in 2018, the Act will repeal all deductions for state and local taxes in excess of $10,000. A taxpayer may deduct up to $10,000 of state property or income taxes (or sales taxes in lieu of income taxes). For many people, it will be beneficial to pay the remaining balance due on any 2017 state income or property taxes in December, provided they are not currently subject to the Alternative Minimum Tax (AMT) and will not become subject as a result of those payments. The Act prohibits any deduction in 2017 for 2018 state taxes that are paid during 2017, so there is likely no benefit to prepayments of anticipated taxes owed for 2018. An accountant can help with this analysis.
Home mortgage interest. After December 31, 2017, the Act reduces the maximum amount of home mortgage loan on which interest can be deducted from $1,000,000 to $750,000. Existing loans incurred before December 15, 2017, are grandfathered at the prior $1,000,000 amount. The deduction of interest on home equity loans of up to $100,000 loan amount is repealed beginning in 2018. There is an exception to this limitation when a home equity loan is considered “acquisition indebtedness.” Acquisition indebtedness is determined if the proceeds from a home equity loan are used to acquire another home or make substantial improvements to the taxpayer’s residence, with a caveat that all mortgage loans combined do not exceed the previously stated thresholds.
Medical expenses. The Act leaves intact the deduction for medical expenses, which the House bill would have repealed. For 2017 and 2018, the adjusted gross income threshold above which medical expenses may be deducted is lowered from 10% to 7.5% for purposes of the regular income tax and the AMT.
Alimony payments. The Act repeals the deduction for alimony payments and establishes that the spouse receiving alimony will not be taxed on such amounts but not until after 2018.
Casualty losses. The Act limits the deduction for casualty losses to losses sustained from events declared by the president to be disasters beginning in 2018.
Miscellaneous itemized deductions. The Act repeals all the miscellaneous itemized deductions that were subject to the floor of 2% of adjusted gross income beginning in 2018. This encompasses a variety of deductions, including fees for tax return preparation, unreimbursed employee business expenses, investment fees and expenses, and union and professional dues.
Student loan interest. The Act leaves intact the deduction for interest expense incurred on a student loan. This deduction would have been repealed by the House bill.
Child tax credit. The child tax credit has been increased from $1,000 to $2,000 per qualifying child. This credit phases out for taxpayers whose taxable income is over $400,000 for married couples and over $200,000 in all other cases. There’s also a new, nonrefundable credit of $500 for each dependent who is not a qualifying child.
Overall limitation on itemized deductions. The phase-out of itemized deductions is repealed for tax years after 2017.
Alternative Minimum Tax
The alternative minimum tax will remain a part of our tax system for individuals with an increase of the exemption amount to $109,400 for married taxpayers filing a joint return and $70,300 for single individuals. The income level where the exemption phases out was increased to $1,000,000 for married taxpayers filing a joint return and $500,000 for single individuals. Many people who were subject to the AMT in the past will find it no longer applies to them beginning in 2018. For many people, the principal item that caused them to become subject to AMT was the deduction of state and local income and property taxes. Beginning in 2018, this deduction will be limited to $10,000 per year, which will result in fewer people being subject to AMT. The deduction of miscellaneous itemized deductions also contributed to individuals becoming subject to AMT, and these deductions are also repealed beginning in 2018.
The Act did repeal the corporate alternative minimum tax, which the Senate Bill would have retained. Considerable concern had been raised that retaining the corporate alternative minimum tax would have taken away much of the value of certain tax credits, e.g. the research and development credit.
Business Income Received by Individuals and From Pass-Through Entities
The Act generally followed the approach adopted by the Senate regarding income received by individuals from pass-through entities and proprietorship businesses. New IRC Section 199A provides a deduction in the amount of 20% of the taxpayer’s net qualified business income, which results in a maximum effective income tax rate on qualified business income of 29.6% when coupled with the 37% maximum income tax rate. The deduction is limited to an amount equal to the greater of (a) 50% of the W-2 wages paid by the business or (b) the sum of 25% of the W-2 wages paid by the business and 2.5% of the unadjusted tax basis of the depreciable assets used in the business whose depreciation life has not expired. For this purpose, an asset is given a minimum depreciation life of 10 years. The use of “unadjusted basis” will generally mean that depreciable assets will be considered at their original purchase cost when computing the 2.5% number. This limitation establishes a significant advantage for businesses that employ significant numbers of people or significant amounts of capital. There is an exception to this limitation for individuals with taxable income of less than $157,500 or married couples filing jointly with taxable income of less than $315,000 of taxable income. In both cases, taxable income does not take into consideration the pass-through deduction. Furthermore, the deduction phases out over the next $50,000 of taxable income for individuals and over the next $100,000 of taxable income for married couples filing jointly, with both phase-out intervals being subject to inflation adjustments.
The provision is not applicable to service-based businesses except for those earning below the above threshold amount. Engineering and architectural firms were excluded from the prohibition generally applied to service-based businesses.
Qualified business income does not include income earned outside of the United States (except for Puerto Rico), investment income such as interest (other than interest generated by the business), dividends or dividend or dividend equivalent amounts, commodities gains, foreign currency gains, income received from notional principal contracts (derivatives), and income from annuities not related to the business. All short and long-term capital gains are excluded as well.
Dividends from REITS (excluding capital gain dividends), dividends from cooperatives, and income from a qualified publicly traded partnership also qualify for the 20% pass-through deduction.
A carried interest is generally an interest in future profits to be earned by a partnership or limited liability company that a service provider will receive. The interest is generally granted for the performance of services rather than the provision of capital to the business. Critics of the existing carried interest rule have suggested that it is not good tax policy to permit an employee to ultimately recognize capital gain income as compensation for services. The Act preserves current law treatment of carried interests; however, the interest must be held for a minimum of three years in order to result in capital gain treatment for the service provider.
Limitation on the Deduction of Business Losses
For taxpayers other than corporations, business losses in excess of $250,000 for an unmarried taxpayer and $500,000 for a married couple filing jointly cannot be deducted against other non-business income after 2017. Any disallowed amounts will be carried forward as a net operating loss, which can be deducted against business income in future years. There is an exception to this limitation when all or part of the tax year’s loss is considered a “farming loss.” Farming losses are permitted to be carried back two years.
IRC Section 1031 is amended to limit tax-deferred exchanges to those involving real property. Exchanges of like-kind personal property will be subject to taxation after 2017. The most significant impact of this change for many high net worth families is that it will no longer be possible to do like-kind exchanges of aircraft and works of art.
Sale of Stock
The House bill contained a provision that would have eliminated a taxpayer’s ability to “specifically identify” the particular shares of stock that had been sold by the taxpayer. This rule allows a taxpayer to choose its shares having the highest tax basis. Under the House bill, taxpayers would have been required to use the “first in-first out” identification method, which would have resulted in higher taxes where the taxpayer’s earliest purchased shares were purchased at the lowest price. As the Act did not include this provision, taxpayers will still be permitted to specifically identify the shares that they sell.
Section 529 Plans
The Act expands the levels of education for which expenses can be paid with funds held in Section 529 plans. Currently, such funds can only be used for expenses related to post-secondary education. Beginning in 2018, up to $10,000 per student per year can be used to pay expenses associated elementary or secondary education, regardless of whether that education is public, private, or religious. A provision that would have allowed the payment of such expenses for homeschooling was removed after the Senate Parliamentarian ruled that the provision violated the Byrd rule because the provision was extraneous to the budget.
Business Tax Reform
Corporate tax rate. The Act permanently lowers the income tax rate for C corporations to 21% beginning in 2018.
Cost recovery. The Act provides for an immediate deduction for 100% of the cost of qualified property placed in service after September 27, 2017, and before January 1, 2023. From 2023 through 2026, the percentage that can be deducted declines 20 percentage points each year. No expensing will be permitted under the provision in 2027. For longer production property and certain aircraft, the deductible amount begins declining by 20 percentage points each year from 2024 through 2027. The provision will apply to used property as well as new property. In general, qualified property is personal property with a depreciable life of 20 years or less and also includes motion picture and television productions for which a deduction would have been allowed under Section 181 (without regard to the dollar limitations imposed by that section). Property used in a real estate trade or business does not qualify.
Cost recovery with respect to real property. The Conference Agreement dropped a provision in the Senate bill that would have reduced the recovery period for the cost of both residential and nonresidential real property from 39 years and 27.5 years respectively to 25 years for both types of property. The 39 year and 27.5 year periods will remain in effect. The Conference Agreement did follow the Senate bill in consolidating qualified improvement property, qualified leasehold improvement property, and qualified restaurant property into a new single definition called “qualified improvement property.” This property includes any improvement made to a nonresidential building after the building has been placed in service but does not include expenditures for enlarging the building, escalators or elevators, or the internal structural framework of the building. Expenditures constituting qualified improvement property can be depreciated over 15 years.
Increase in the amount that can be expensed under IRC Section 179. The Act increased the amount that can be expensed under IRC Section 179 to $1,000,000 beginning in 2018. Additionally, it increases the amount where the phase-out of the deduction begins to $2,500,000.
Business interest expense. Beginning in 2018, the deduction of interest by a business would be limited to 30% of its adjusted taxable income plus the amount of business interest income. For tax years beginning before January 1, 2022, taxable income is increased by the amount of deductions taken for depreciation, depletion, and amortization thereby yielding a higher deduction limit. An exception to the limitation is provided for businesses having average gross receipts of $25 million or less for the three prior taxable years. Real property businesses can elect to be exempted from the limitation by agreeing to use the alternative depreciation system, which results in somewhat longer depreciation periods for buildings.
Limitation on deduction of net operating losses. The JCTA repeals the 2-year carryback period for net operating losses incurred after 2017 but allows an indefinite carryover period. Only 80% of taxable income may be eliminated by a net operating loss deduction after 2017.
Repatriation of Foreign Earnings. The bifurcated effective tax rates for the transitional deemed repatriation of foreign earnings are higher than under the earlier bills, ending up at 15.5% (for cash and cash equivalents) and 8% (for earnings invested in non-cash assets).
Corporate Compensation Provisions
Revises the definition of a covered employee. The definition of a covered employee to an applicable employer has been revised to include anyone who served as the principal executive officer or the principal financial officer at any time during the year and the three other most highly compensated officers for the taxable year. Also, anyone who is a covered employee in 2017 or later will always be considered a covered employee.
Provision taxing deferred compensation on vesting is dropped. A provision of the Senate bill that would include deferred compensation in income when it is no longer subject to a “substantial risk of forfeiture” – effectively on vesting – even if not payable until a future year was dropped by the Conference Committee.
Limitations on executive compensation. Section 162(m) currently imposes an annual limit of $1,000,000 on the deductibility of compensation paid by a public company to each of its covered employees (the CEO and the three other highest-paid executive officers excluding the CFO). The Act amends Section 162(m) to repeal prior exceptions for performance-based compensation including stock options and commissions and expands the list of covered employees to include the CFO. Once an employee is covered, they will continue to be included for as long as they receive compensation from the company (including after termination of employment). The amendment applies to taxable years beginning after December 31, 2017, with a grandfather provision for contracts that were binding on November 2, 2017.
Excise tax on executive compensation paid by tax-exempt organizations. The Act imposes a 21% excise tax on tax-exempt employers for payment of compensation in excess of $1,000,000 to the five highest paid employees of the organization.
Deferral of qualified broad-based equity awards. The Act allows employees who are granted stock options or restricted stock units through a broad-based employee plan covering at least 80% of employees to elect to defer recognition of gain on exercise of the options or vesting of the units for up to five years if such election is made within 30 days after such rights vest or become transferable. However, such a plan and election are not available to 1% owners or the four highest compensated officers.
Individual Compensation Provisions
Withholding. The IRS has issued new withholding tables that take effect no later than February 15, 2018. Furthermore, a withholding calculator is available at IRS.gov, which allows individuals to review and compare the amount of Federal taxes their employer is withholding on each paycheck to the withholding amount determined by the calculator. Filing a new W-4 tax form may be advantageous when an employee’s withholding amount (determined by the W-4 tax form the employer has on file) and the amount determined by the calculator vary. Doing so helps ensure the appropriate amount of Federal income taxes are being withheld from each paycheck.
Recharacterizations. Recharacterizations can no longer be used to unwind a Roth IRA conversion. Further, contributions to a Roth IRA can no longer be recharacterized as a contribution to a traditional IRA. However, a taxpayer can recharacterize a current year traditional or Roth IRA contribution to the other type of contribution before the due date for the individual’s return (the IRS issued an FAQ on January 18, 2018, that states 2017 conversions can be recharacterized until October 15, 2018).
Retirement plans – rollover of qualified plan loan offsets. The deadline to avoid having a qualified plan loan be treated as a taxable distribution because of an individual’s separation from service or in the event of plan termination has been extended from 60 days to the due date for filing an individual’s Federal income tax return (for the tax year the loan offset occurs). If the plan permits, employees may also rollover the loan balance to an eligible retirement plan by the same deadline.
SNAPSHOT COMPARISON: NOTABLE PROVISIONS
Note: (1) highlighted areas indicate items of change from prior proposals in the Senate’s bill and (2) provisions noted as expiring will revert to current law at the start of the specified year.
It appears almost certain that the Act will be signed into law by year-end and will have a significant effect on individuals and businesses at all income levels for years to come. Mezrah Consulting will continue to report on any changes in tax provisions and, more specifically, any taxation regarding deferred compensation plans that could impact the executive and/or the company. As always, thank you for your relationship and confidence. It is appreciated.