On Tuesday, December 19th, the House passed the tax reform bill with a vote of 227-203. The tax bill hit a late snag on Tuesday afternoon, as the Senate parliamentarian noted that the House-passed bill contained three minor provisions that violated Senate rules, thus requiring slight modifications. After further deliberations, the Senate passed the bill (with the struck-down provisions) early Wednesday morning with a vote of 51-48. Given the bill’s required changes to meet Senate rules, the tax bill then returned to the House for another vote, with the House passing the updated version on Wednesday. Having now passed both the House and Senate, the bill now heads to President Trump to sign the bill into law. The article that follows highlights key provisions of the final tax bill as well as several year-end planning opportunities.
The new tax bill incorporates a wide range of changes for individual taxes, though most of the tax cut provisions (for individuals) are structured to expire after 2025 due to Senate budget rules. GOP leadership has emphasized that a future Congress could choose to extend any expiring tax provisions.
Income Tax Brackets
While the House tax bill initially reduced the number of tax brackets from seven to four, the Senate tax bill and the conference agreement retained seven brackets, with the top bracket falling from 39.6% to 37%.
Alternative Minimum Tax (AMT) – the House tax bill called for the elimination of the AMT, though both the Senate tax bill and the conference agreement ultimately retained the AMT (much to the chagrin of the more than four million households that are subject to the AMT).
- While the AMT system is still in place for individuals, the amount that taxpayers can deduct from alternative minimum taxable income (the ‘AMT exemption’) would increase from $84,500 to $109,400 for joint filers and from $54,300 to $70,300 for other filers.
- In addition, the phaseout range that applies to the AMT exemption would increase significantly from $160,900 to $1,000,000 for joint filers and from $120,700 to $500,000 for other filers.
- Between the increased exemption amounts and phaseout ranges, fewer households will be subject to the AMT, and those subject to AMT will likely owe a smaller amount under the new tax bill.
Pass-Through Income – pass-through owners that meet certain conditions would be able to deduct up to 20% of “qualified business income” from a partnership, S-corporation, or sole proprietorship.
- The 20% deduction phases out over the following income ranges: $315,000-$415,000 for joint filers and $157,500-$207,500 for other filers.
- Owners of certain service businesses (such as law, medical, and accounting firms) are only eligible for the deduction if income falls below the initial threshold ($315,000 for joint filers, and $157,500 for other filers).
Estate, Gift, and Generation-Skipping Transfer Tax – existing exemptions would approximately double to $11.2MM per person and would be indexed annually for inflation. The exemption amounts would revert back to current levels after 2025.
- There had been some discussion whether the step-up in cost basis at death would be eliminated, though the conference report retains the current basis step-up provision.
Personal Exemption – the exemption is eliminated as of 2018 (for 2017, the exemption is $4,050 each for taxpayers, spouses, and qualified dependents, subject to income limits).
Standard Deduction – the standard deduction approximately doubles under the tax bill:
- For single taxpayers, from $6,350 to $12,000
- For head of household taxpayers, from $9,550 to $18,000
- For married filing jointly taxpayers, from $12,700 to $24,000
Child Tax Credit – the child tax credit increases substantially under the new bill, with the credit changing from $1,000 to $2,000 per child under age 17. The refundable portion of the credit adjusts up to $1,400. In addition, the initial threshold for the phaseout of the credit begins at $400,000 for joint filers (up from $110,000) and at $200,000 for other filers (up from $75,000).
Mortgage Interest Deduction – existing mortgages (pre-12/15/17) are grandfathered under current law with the $1,000,000 mortgage limit, while new mortgages have a $750,000 limit.
Home Equity Loan Interest Deduction – this deduction is eliminated as of 2018.
State & Local Tax Deduction (‘SALT’) – this deduction was a point of contention between the House and Senate tax bills, with the conference agreement ultimately allowing taxpayers to deduct up to $10,000 (total) for property taxes plus the greater of state and local income taxes or sales taxes.
Charitable Donations – this deduction was not impacted by the tax bill, with the exception that cash contributions to public charities will now be allowed up to 60% of adjusted gross income (rather than the current 50% of AGI limit).
Medical Expense Deduction – the bill drops the threshold for the deduction to 7.5% of Adjusted Gross Income (AGI) for 2017 and 2018, with the threshold increasing back to 10% of AGI as of 2019.
Miscellaneous Itemized Deductions – the bill eliminates all miscellaneous itemized deductions (for example, unreimbursed job expenses, investment expenses, tax preparation fees, legal expenses, etc.).
529 Plans – these plans are typically designated for higher education expenses, though the new bill allows these plans to distribute up to $10,000 per child per year for K-12 expenses.
Alimony – for divorce or separation agreements executed after December 31, 2018, alimony and separation maintenance payments will be neither deductible by the payor spouse, nor taxable income for the payee (recipient) spouse.
Retirement Account/Plan Provisions
Retirement Plan Contributions – initial proposals had considered limiting pre-tax contributions to retirement plans with a requirement that certain contributions be made on after-tax basis (referred to as ‘Rothification’). In the end, the bills did not impact/alter retirement contributions.
Roth IRA Recharacterizations – under current law, a taxpayer who completes a Roth conversion has until October 15th of the following year to unwind a Roth conversion (which treats the Roth conversion as though it had never happened). This ‘do-over’ maneuver is eliminated as of 1/1/2018.
Non-Qualified Deferred Compensation Plans – the final bill did not incorporate any changes to these plans.
Outstanding Retirement Plan Loans – under the final bill, participants who separate from service with an outstanding loan against their plan balance have until the tax return due date for that year to repay the loan balance to an IRA (effective as of 1/1/2018).
Corporate Tax Rate – the tax bill permanently cuts the top 35% corporate tax rate to 21% as of 2018.
Corporate Alternative Minimum Tax (AMT) – the tax bill permanently repeals the corporate AMT.
Taxation of Multi-National Corporations – the bill shifts the U.S. from a worldwide system to a territorial system in which only domestic profits would be taxed. The bill includes certain anti-abuse tax provisions.
Deemed Repatriation – currently deferred foreign profits will be deemed and taxed as repatriated at 15.5% for liquid assets and 8.0% for illiquid assets.
Now that taxpayers have seen the updated version of the tax reform rules and provisions, there are a few tax planning strategies that can be executed prior to year-end.
Some of the following planning considerations relate to managing itemized deductions. Given that the Alternative Minimum Tax (AMT) disallows deductions such as state and local income taxes and property taxes (among others), taxpayers should determine whether they are likely to be subject to AMT and the resulting impact of executing any of these planning items in 2017.
Currently, approximately 30% of taxpayers (approximately 45 million) itemize deductions; with the standard deduction nearly doubling, it is estimated that as many as 25 million taxpayers would no longer itemize deductions, choosing instead to take the increased standard deduction.
Going forward (2018 and beyond), itemized deductions will primarily consist of:
- Medical Expense Deduction
- State and Local Tax (‘SALT’) Deduction (capped at $10,000 for the total of property taxes plus either state and local income taxes or sales taxes)
- Mortgage Interest Deduction
- Charitable Deduction
1) Accelerate Charitable Gifts into a Single Tax Year
Taxpayers should review itemized deductions excluding charitable donations under the new rules to determine what portion (if any) of charitable gifting would not produce a tax benefit. If a portion of charitable gifting would not produce a tax benefit, taxpayers would be incentivized to accelerate charitable gifting into a single year (to maximize itemized deductions in a single tax year) while taking the standard deduction in other years.
For example, Rob and Maria have mortgage interest of approximately $8,000 and state and local taxes of $10,000 (new limit). Since their standard deduction has increased to $24,000, the first $6,000 of charitable giving would not produce a tax benefit (calculated as $24,000 – $8,000 – $10,000); any gifting beyond $6,000 would produce a tax benefit as Rob and Maria’s itemized deductions would then be greater than the $24,000 standard deduction. Rob and Maria typically give $10,000 to charity each year. In this case, Rob and Maria could choose to group multiple years’ of gifting into a single year (e.g. giving $40,000 in one tax year, while opting for the standard deduction in the following three years). If Rob and Maria would still prefer to do a level amount of charitable giving each year, they could utilize a donor-advised fund (ideally gifting long-term appreciated securities rather than cash) to get the tax deduction in a single tax year while making subsequent distributions from the donor-advised fund at a pace of their choosing.
In addition, if a taxpayers’ tax rate (while also factoring in the potential for AMT) is likely to be lower in 2018 than in 2017, the taxpayer would benefit from greater charitable giving in 2017.
2) Pre-Pay Taxes (if possible)
As noted earlier, popular itemized deductions such as state and local income taxes and property taxes are disallowed under the Alternative Minimum Tax (AMT). To the extent a taxpayer is not likely to be subject to AMT in 2017, the taxpayer should consider prepaying state and local income taxes and property taxes (attributable to the 2017 tax year) before 12/31/2017 (given the new $10,000 limit on the ‘SALT’ deduction that will be applicable as of the 2018 tax year).
It is important to note that the conference agreement closed the loophole allowing taxpayers to prepay taxes. State and local income taxes attributable to the 2018 tax year would be claimed as a 2018 itemized deduction (meaning, a taxpayer cannot prepay income taxes for the 2018 tax year in 2017 and claim a 2017 itemized deduction).
3) Pre-Pay Miscellaneous Itemized Deductions
To the extent a taxpayer is not likely to be subject to AMT in 2017, consider pre-paying miscellaneous itemized deductions such as tax preparation fees or investment advisory fees, as these miscellaneous deductions are eliminated under the new tax bill. Many of the miscellaneous itemized deductions fall into a category in which the sum must exceed 2% of Adjusted Gross Income (AGI), for which the portion exceeding the 2% AGI limit is deductible.
4) Defer Income
Salaried employees will likely have limited ability to defer income, though business owners may have greater flexibility in deferring income into 2018 if the projected tax rate for 2018 would be lower than that for the 2017 tax year.
5) Potentially Reverse a 2017 Roth Conversion
The new tax bill would eliminate taxpayers’ ability to unwind Roth conversions (‘Roth recharacterization’) as of 1/1/2018. Taxpayers that completed a 2017 Roth conversion are likely to have benefited given significant 2017 market gains (and thus less likely to want to unwind a successful Roth conversion); that said, certain taxpayers might have unique 2017 tax considerations for which unwinding a portion of the Roth conversion could make sense.
6) Consider Utilizing the IRA Charitable Rollover
Charitably inclined taxpayers over age 70½ might consider using an IRA Charitable Rollover to satisfy Required Minimum Distributions (RMDs). Taxpayers over age 70½ can transfer up to $100,000 each year to charity; the distribution neither counts as taxable income nor an itemized deduction. Since some taxpayers may see a portion of their charitable giving provide less tax benefit (as explained above, due to the increased standard deduction), using this provision leverages the effectiveness of charitable giving.