Tax Cuts and Jobs Act Puts Greater Emphasis on Planning
Upping the Ante
By Kristina Drzal Houghton, CPA, MST
It’s June. This is generally not the time to be thinking about taxes. In reality, though, businesses and individuals should always be contemplated taxes and how to reduce their burden. And the Tax Cuts and Jobs Act signed into law late last year gives people even more to think about.
The Tax Cuts and Jobs Act, (TCJA), signed into law on Dec. 22, 2017, brought the biggest changes to both individual and corporate taxes that we’ve seen in the past 30 years. These changes were primarily effective for tax years 2018 and after. For many reasons I’ll highlight in this article, these changes make starting your planning early extremely important.
I will briefly acknowledge that the TCJA reduced the C-corporation tax rate to a flat 21%, from the previous maximum rate of 34%. Additionally, there were changes made to U.S. taxation of income earned abroad by U.S. C-corporations and their affiliates.
The focus of this article will revolve around planning for individuals and small businesses.
Where to Start
I would suggest having an accountant run mock 2018 returns as a starting point. Running those future numbers can flag potential issues. That said, state revenue departments and the Internal Revenue Service have had little time to process the changes, so much remains in flux. The IRS and states haven’t decided how some provisions of the new tax law will be calculated yet. I expect that the IRS and states will start to share their 2018 guidance later this summer. In the meantime, here are some suggestions:
Rework Your Withholding
The new law means that the W-4 you filled out, however many years ago, may need to be adjusted. The IRS encourages everyone to use the Withholding Calculator, available on irs.gov, to perform a quick ‘paycheck checkup.’ Remember, the new tables don’t reflect all the changes that may affect a taxpayer next year, so they are a somewhat blunt tool.
The calculator helps you identify your tax withholding to make sure you have the right amount of tax withheld from your paycheck at work.
If workers leave their W-4s as is, they could wind up withholding too little, which can bring penalties, or they may get a smaller-than-expected refund next year. Workers in higher tax brackets who receive large bonuses could see a higher tax bill next season if they don’t tweak W-4s, since one of the ways employers can set the withholding rate on ‘supplemental income’ such as bonuses in the new law is to use a flat rate of 22%.
Think About Deduction Planning
A big change that could affect many taxpayers is the tax overhaul’s controversial cap on state and local income tax (SALT) deductions, a provision Democrats have labeled a war on blue-state Americans. The deduction, which used to be unlimited, will be capped at $10,000 next year. The new law’s near-doubling of the standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly does mean fewer will itemize.
States were busy devising workarounds to keep those residents from seeing a big spike in federal taxes next year, but the IRS recently informed taxpayers that proposed regulations will be issued addressing the deduction of contributions to state and local governments and other state-specified funds, for federal tax purposes. The proposed regulations will make clear that the Internal Revenue Code, not the label used by states, governs the federal income-tax treatment of such transfers.
As a result of the decreased SALT deduction and the increased standard deduction, the tax benefit from charitable contributions may be lost if the standard deduction exceeds itemized deductions. One strategy for people who regularly donate to charity is to bunch up into one year what they would have given over multiple years. For those who itemize, charitable donations remain deductible on federal returns and can help lift married taxpayers who file jointly above the $24,000 standard deduction hurdle.
By putting a few years’ worth of donations into a donor-advised fund — many financial-services firms have units that offer them — you can take the deduction the year you put the money in, but distribute the money to charity over multiple years. For taxpayers older than 70½ who are taking required distributions from an IRA, they should consider making distributions to charities directly from their IRA.
Mortgage and Home-equity Loan Deductions
The new tax law lowered the amount of deductible interest expense on ‘acquisition indebtedness.’ For new loans made after Dec. 14, 2017, the maximum interest is limited to a mortgage ceiling of $750,000; previously, this was $1 million. It also eliminated the interest deduction on loans, such as home-equity loans, that are not used to ‘buy, build, or substantially improve’ a home.
New College Savings Plan Uses
The new tax law expands the allowable use of tax-exempt 529 college savings plans for education costs that accrue while your child is between kindergarten and high-school graduation. This added allowable use is limited to $10,000 per year per beneficiary. But be careful — while some states automatically follow the federal code, others choose to decouple from certain parts of it. So, while the U.S. government may say you can use 529 money for K-12 expenses, a state may consider such a withdrawal a non-qualified distribution and could tax the earnings and charge you penalties.
Section 199A Pass-through Optimization
Section 199A, which is a new section of the tax code arising from the Tax Cuts & Jobs Act of 2017, introduces a 20% deduction on qualified business income (QBI) for the owners of various pass-through business entities which include S-corporations, limited liability companies, partnerships, and sole proprietorships — or, really, any business that is not a C-corporation.
The QBI deduction will provide big tax breaks for many business-owning clients, but unfortunately, the new deduction is highly complicated, and it may take some time before the IRS can even provide more meaningful guidance on how it will be applied. However, the reality is that the planning opportunities created by IRC Section 199A are tremendous, and practitioners are already eagerly exploring how they can help clients reduce their tax burden through creative strategies around the QBI deduction.
Business owners will generally fall within one of three categories when it comes to the QBI deduction:
• Business owners below their applicable threshold amount — which is $157,500 of taxable income for all filers except joint filers, and $315,000 for those filing jointly — can enjoy a QBI deduction for the lesser of 20% of their qualified business income or 20% of their taxable income. It does not matter what type of business is generating the income, nor is there a need to analyze W-2 wages paid by the business or depreciable assets owned by the business. The QBI deduction is what it is.
• Business owners over their applicable threshold who derive their income from a ‘specified service’ business (i.e., some specialized trade or service business) — which includes doctors, lawyers, CPAs, financial advisors, athletes, musicians, and any business in which the principal asset of the business is the skill or reputation of one or more of its employees — will have their QBI deduction phased out. The phase-out range is $50,000 for all filers except joint filers, and $100,000 for those filing jointly. Once a business owner’s taxable income exceeds the upper range of their phase-out threshold ($207,500 for individuals and $415,000 for married filing jointly), they cannot claim a QBI deduction for income generated from a specialized trade or service business. Period. End of story. ‘Do not pass go, do not collect $200.’
• Business owners over their applicable threshold who derive their income from a business that is not a specialized trade or service business may also have their QBI deduction at least partially phased out, but the full deduction may be ‘saved’ based on how much they pay in W-2 wages and/or how much depreciable property they have in the business. Business owners with qualified business income from non-specified service businesses whose taxable income exceeds the upper range of their phase-out threshold can still take a QBI deduction equal to or less than the greater of:
1. 50% of the W-2 wages paid by the business generating the qualified business income; or
2. 25% of the W-2 wages paid by the business generating the qualified business income, plus 2.5% of the unadjusted basis of depreciable property owned by the business.
A careful analysis of the rules above will lead one to realize that, when it comes to maximizing a business owner’s opportunity for a QBI deduction, strategies will fall into one of three main buckets:
• Income-reduction strategies, such as trying to lower taxable income by increasing deductions or spreading out the income over multiple taxpayers, to stay below the income threshold where the specified service business or wage-and-property tests kick in;
• ‘Income alchemy’ strategies, where we try to transform income derived from a specified service business into income derived from a company that is not a specified service business, to avoid the phase-out (for those over the income threshold); and
• Business strategies, such as changing an entity, revisiting compensation models, and revisiting business assets, to more favorably characterize business income in the first place.
Relook at Filing Separate Returns for Married Couples
The tax code has long limited married couples filing separate returns from taking advantage of a number of tax breaks, either by barring those tax breaks entirely under the ‘married filing separately’ status, or phasing them out at very modest income thresholds. As a result, in the past, it’s rarely been a tax-efficient move for married couples to file separate returns, except in highly unusual circumstances. That will likely still be the case for most married couples, but the creation of the QBI deduction does tilt the balance somewhat for some couples.
Should You Revoke S-corp Status?
The hot question since the passage of the Tax Cuts & Jobs Act of 2017 and Section 199A is, “should I revoke S-corp status and go to C-corp?” The answer is no.
While the TCJA reduced C-corporation tax rates to 21%, the QBI reduces the maximum rate on pass-through income to 29.6% (80% of 37%). Previously, the maximum tax rate on pass-through income was 39.6% plus the effect this income had on itemized deduction and personal exemption phase-outs, producing an even greater effective rate.
This rate exceeded the prior maximum C-corporation rate of 34%. Owners elected to operate their businesses in pass-through entities for many reasons beyond the current year’s tax. None of these considerations have changed.
For most small businesses and their owners, the key point is to acknowledge that TCJA creates a tremendous number of planning opportunities. New strategies with QBI will certainly continue to be developed with time and further guidance from the IRS, but even in the present, there exists enough reasons to reach out to your advisors and have them help them reduce your tax liabilities.
Kristina Drzal Houghton, CPA, MST is a partner and director of the Taxation Division at Holyoke-based Meyers Brothers Kalicka; (413) 536-8510.