The 2017 Tax Cuts and Jobs Act was signed into law on December 22. Since that time, tax professionals, financial advisors and attorneys have scrambled to understand the impact of the new legislation on their clients. As the 2017 tax filing season kicks off, many HBK clients are asking us what they need to do now to put themselves in the best tax situation for the 2018 tax year. Following is a discussion of some of the major provisions that will significantly impact many individuals and businesses. As most of these changes relate to the 2018 tax year, they generally will not affect tax returns filed during the 2017 tax filing season.
The New 20% Deduction for Pass-Through Businesses
One of the goals of the Tax Act was to simplify the code, which was done by eliminating many deductions and credits that businesses and individuals have historically relied on to reduce their tax bill. But eliminating these deductions and credits would likely increase taxes, despite a rate reduction, for many of the tax brackets. So Congress introduced a new 20 percent deduction for so-called “pass-through” businesses, essentially businesses like S-corporations and partnerships that don’t pay corporate taxes. Congress also wished to provide pass-through entities a tax benefit similar to what C-corporations received with their new 21 percent flat tax rate.
Calculating the deduction is complicated, and becomes even more complicated when an individual’s taxable income exceeds $315,000 (married filing joint) or $157,500 (single). If taxable income is below these thresholds, all types of businesses can take the new deduction, and the calculation is relatively straightforward. The allowable deduction is equal to 20 percent of a business’s qualified business income, though cannot exceed 20 percent of the individual’s taxable income less net capital gains. The Tax Act defines “qualified business income,” but the definition is littered with technical language that makes it more complicated than it should be. For most individuals, qualified business income will likely be the ordinary income of the business, though it does not include wages or guaranteed payments that the individual may receive from the business.
Once an individual’s taxable income exceeds $315,000 or $157,5000, the type of business that qualifies for the deduction changes. Once that threshold is crossed, then “specified service businesses” must phase out their deduction. The deduction is completely lost when the individual’s taxable income exceeds $415,000 (married filing joint) or $207,500 (single). The Tax Act defines “specified service business,” but the definition is broad and would appear to apply to many types of businesses. Without further guidance, it is difficult to say with certainty whether or not a business that is not specifically listed in the definition will be considered a “specified service business” and subject to the deduction phase-out.
For businesses not subject to the phase-out, the allowable deduction is subject to additional limitations, which make the calculation that much more complicated. We encourage everyone to contact their tax professional to walk through the calculation and determine whether or not they will benefit from the deduction, and how much of a deduction they can expect.
The Tax Act effectively eliminates the ability of a business to deduct most – if not all – entertainment expenses – typically entertainment, amusement, or recreation – even if there is a business purpose for the expense. Types of expenses can include expenditures at country clubs, or for sporting events, hunting or fishing trips, or theaters. For a business that spends a significant amount on these types of events to network and attract new clients, eliminating these deductions could result in a significant increase to taxable income. We’ll discuss the specifics of this disallowance in a future article, as the rules are lengthy and the impact on businesses potentially substantial.
New Measure of Inflation
Historically, tax brackets and thresholds within the tax code have increased with inflation, which is calculated using the Consumer Price Index (CPI). The CPI lists prices that consumers typically pay for retail goods and other items. As the cost of these goods and items increase, so do the tax brackets and thresholds. The Tax Act changed the inflation calculation so that it will now use the Chained Consumer Price Index (C-CPI-U). The C-CPI-U assumes customers will choose less expensive substitutes for retail goods and other items as prices increase, and therefore slows the rise in inflation.
The overall effect of this change is that tax brackets and thresholds that increase with inflation will now increase at a slower rate than they have historically. Over time, this essentially causes an increase in taxes paid because more income will be subject to higher tax rates than would have been using the CPI.
Changes to Itemized Deductions
In developing the provisions of the Tax Act, there was considerable debate regarding a limitation on the deduction for state and local taxes. In the end, Congress decided to limit the deduction for all state and local taxes to $10,000. This limitation applies only to personal taxes, and does not apply to trade or business taxes that would be deductible against business income. For individuals living in states with high income and property tax rates, this limitation could result in a large increase in tax that might not be offset by a lower tax bracket. High tax states are currently looking at creative ways to maintain their tax revenues while providing residents ways to achieve a greater federal tax deduction.
Another new restriction on itemized deductions is the elimination of the deduction for miscellaneous itemized deductions, which currently are allowed to the extent they exceed 2 percent of adjusted gross income. These deductions include tax preparation fees, investment management fees, and unreimbursed employee expenses. It should be noted that the deduction for tax preparation fees related to the preparation of a trade or business return are not eliminated.
The amount of mortgage interest that is deductible has also been reduced for mortgages entered into after December 15, 2017. The interest from these mortgages will only be deductible for principal balances up to $750,000. Any interest related to balances in excess of this threshold will not be deductible. Mortgages that were entered into prior to December 15, 2017 will be subject to the old mortgage interest rules, which allow interest on principal balances up to $1 million. If an older mortgage is refinanced, the old mortgage interest rules will apply. In addition, interest paid on home equity lines of credit with balances up to $100,000 will no longer be deductible.
While most changes relating to itemized deductions result in fewer deductions that can be claimed, the Tax Act did provide one benefit for itemizers: the elimination of the overall limitation on itemized deductions. The so-called “Pease limitation” applied when an individual’s taxable income exceeded certain thresholds, and caused a significant reduction in itemized deductions that many individuals could claim.
Proactive Planning Is Crucial
The 2017 Tax Cuts and Jobs Act represents the most significant change to the internal revenue code in the past 30 years. Its impact will be significant over the next eight years. There are many other changes not covered in this article that could affect your personal tax situation. It is crucial that individuals and businesses engage in proactive planning to prepare for the changes and to take advantage of any new applicable tax benefits. At HBK we are committed to working with you to ensure your planning needs are met. We encourage you to reach out and ask questions, and we will do our best to provide you with the highest level of service.