Tax reform

Year-End Planning and Tax Reform

How legislative proposals may affect you

After nearly a year of controlling both the executive and legislative branches, House and Senate Republicans are quickly moving forward with sweeping federal tax reform legislation.

Representatives passed their own bill on November 16. The Senate Finance Committee approved its version that same night, and Republican Senators reportedly plan to vote on it this week.

Assuming they can continue to keep pace and send a legislative package to President Donald Trump by Christmas, most of the proposed changes are intended to take effect in 2018. There are some areas where the two houses have broad agreement, and others that will require more negotiation. Here’s how the proposals compare.

Biggest winners

Although the news headlines focus on the potential impact on individual taxpayers, the biggest winners under the present draft of tax law revisions appear to be businesses and the potential heirs of our nation’s wealthiest families with these substantial changes:

Lower corporate income tax rate

House — The bill would replace the graduated corporate tax rate structure (currently with a 35% maximum) with a 20% flat rate. The corporate alternative minimum tax (AMT) would be repealed.

Senate — Same as the House bill, but the 20% flat rate would apply to tax years beginning after December 31, 2018.

New preferential tax rate for individual business owners

House — The bill would create a new 25% tax rate for “qualified business income” reported by individual taxpayers who own interests in certain businesses operated as sole proprietorships, limited liability companies, partnerships and S corporations. The lower rate would generally apply to 100% of the net passive income reported, but only 30% of net non-passive (or “active”) business income reported. The term passive income would have the same meaning as under the current passive activity rules; generally, someone who works less than 500 hours at the business.

Income from “specified service activities,” which include many personal service businesses, such as the fields of health, law, engineering, accounting, consulting, athletics and financial services, would not qualify for this 25% tax rate.

Senate — Rather than create a special tax rate, the Senate would allow an individual taxpayer to deduct 17.4% of “domestic qualified income” from a partnership, S corporation or sole proprietorship. The deduction would be limited to 50% of the W-2 wages of the taxpayer. If a taxpayer realizes a net loss from the sum of his qualified businesses, the excess net loss is treated as a loss from qualified businesses in the next tax year.

The deduction would not apply to “specified service businesses” unless the individual’s taxable income is less than $75,000, or $150,000 for married filing jointly (MFJ). Where taxable income exceeds this threshold, the deduction would be phased out over the next $25,000 ($50,000 for MFJ) of taxable income.

Business cost recovery

House — The bill would allow businesses to immediately expense 100% of the cost of “qualified property,” which excludes real property, acquired and placed in service after September 27, 2017, and before 2023. Further, the expense limitation would be increased from $500,000 to $5 million.

Senate — Same.

Estate tax phase-out and gift tax reductions

House — The basic exclusion amount, as indexed for inflation, would be doubled from $5 million (as of 2011) to $10 million per person. The estate and generation-skipping transfer tax would be repealed after 2023, while the gift tax would still be in effect. Beneficiaries would continue to receive stepped-up basis for inherited property.

In 2024, the maximum tax rate on non-charitable gifts would be lowered from 40% to 35%, and the basic exclusion of $10 million (indexed for inflation) and annual exclusion of $14,000 (increasing to $15,000 in 2018) would continue to apply.

Senate — No repeal of the estate tax, but would adopt the provision to double the basic exclusion. No change in gift or estate tax rates is proposed.

Key individual income tax proposals

The devil is in the details, but the House and Senate aim to do the following:

Change tax rates and brackets

House — The bill would reduce the number of brackets from seven to four:

  • 12.0% — On the first $45,000 of taxable income for singles, $90,000 for MFJ, $67,500 for head of household (HOH)
  • 25.0% — At $45,001 for singles, $90,001 for MFJ, $67,501 for HOH
  • 35.0% — At $200,001 for singles and HOH, $260,001 for MFJ
  • 39.6% — At $500,001 for singles and HOH, $1 million+ for MFJ
  • The 12% bracket would be phased out for single taxpayers with adjusted gross income (AGI) greater than $1 million and joint filers with AGI greater than $1.2 million.

    Senate — The Senate proposes a revised seven-bracket structure:

  • 10.0% — On the first $9,525 of taxable income for singles, $19,050 for MFJ, $13,600 for HOH
  • 12.0% — At $9,526 for singles, $19,051 for MFJ, $13,601 for HOH
  • 22.5% — At $38,701 for singles, $77,401 for MFJ, $51,801 for HOH
  • 25.0% — At $60,001 for singles and HOH, $120,001 for MFJ
  • 32.5% — At $170,001 for singles and HOH, $290,001 for MFJ
  • 35.0% — At $200,001 for singles and HOH, $390,001 for MFJ
  • 38.6% — At $500,001 for singles and HOH, $1 million+ for MFJ
  • Repeal the alternative minimum tax

    House — Repeal would be effective after 2017. The bill would allow unused minimum tax credits to be claimed beginning in 2019.

    Senate — Adopts the repeal, but the AMT credit would be refundable beginning in 2018.

    Retain the preferential tax rates for investment income

    House — Taxpayers with taxable income not greater than $38,600 ($77,200 for MFJ) would qualify for the 0% rate. The 15% rate would apply where taxable income exceeds those thresholds but is not greater than $425,800 ($479,000 for MFJ). The 20% rate applies in all other cases.

    Senate — Same, however, the basis for any “specified security” sold would be determined on a First In, First Out (FIFO) basis except to the extent the average basis method is allowed (as is the case for mutual funds).

    Restrict the exclusion of gain from the sale of a principal residence

    House — The bill would phase out the exclusion by $1 for every $2 of AGI in excess of the $250,000 ($500,000 for MFJ) exclusion. Also, the new law would require that the seller owned and used the home as a primary residence for at least five of the preceding eight years and allow the exclusion only once every five years.

    Senate — The Senate bill also proposes that the seller must own and use the home as a primary residence for at least five of the preceding eight years and allow the exclusion only once every five years. No AGI phase-out, however.

    Repeal the ability to recharacterize IRA contributions and conversions

    House — The bill would eliminate the ability to treat contributions made to one type of IRA (either traditional or Roth) as if it were a contribution to the other type. It would also repeal the ability to recharacterize (or unwind) conversion distributions from a traditional IRA to a Roth IRA.

    Senate — Same.

    Eliminate certain itemized tax deductions

    House — Taxpayers would no longer be able to deduct alimony, student loan interest, medical expenses, state and local income or sales taxes, moving expenses, unreimbursed employee business expenses, and tax return preparation expenses.

    Senate — Broad repeal of deductions not related to a trade or business, such as alimony, student loan interest, medical expenses, and all miscellaneous itemized deductions that are subject to the 2% floor under current law.

    Cut the deduction for real property taxes

    House — The deduction would be limited to $10,000.

    Senate — Would repeal all property tax deductions unless related to a trade or business.

    Increase the AGI limitation for certain charitable contributions

    House — Cash contributions to public charities would be deductible to the extent the total does not exceed 60% (rather than the current 50%) of the donor’s adjusted gross income.

    Senate — Same.

    Repeal the “Pease” limitation

    House — The 3% reduction to overall itemized deductions for higher-income taxpayers would no longer apply.

    Senate — Same.

    Limit interest deductions for new mortgage debt

    House — The deduction for existing home mortgages would be preserved. The interest deduction for mortgages obtained after November 2, 2017, would be limited to only $500,000 of the debt. Interest paid on home equity loans incurred after that date would not be deductible.

    Senate — The current law regarding mortgage interest deduction would continue to apply, except that the deductibility of home equity loan interest would be repealed.

    Increase standard deduction

    House — The bill would nearly double the standard deduction from $6,350 to $12,000 for single taxpayers, and from $12,700 to $24,000 for MFJ. The deduction for head of household filers would be $18,300.

    Senate — Same for single and MFJ filers. The deduction for head of household filers would be $18,000.

    Increase child tax credit

    House — Proposes to raise the child tax credit by $600 to $1,600.

    Senate — Would nearly double it to $2,000.

    Eliminate personal exemptions

    House — The current exemption is $4,050 for the taxpayer and each dependent.

    Senate — Same.

    What’s Next

    Once the Senate resolves internal opposition and approves its own bill, the two bodies will reconcile the differences and vote on a final bill to be presented to President Trump for enactment. The president has indicated his desire to sign tax reform legislation by Christmas.

    What Should You Do Now

    Both sides still have a lot of work to do before they finalize a tax reform package. Certain areas will receive plenty of debate, such as the elimination of estate taxes and the treatment of business income, and the outcome is hard to predict. To avoid Democratic filibuster, the final Senate tax bill must not increase the deficit by more than the $1.5 trillion allowance built into the Republican-backed budget passed in October.

    Therefore, for most people, we advise continuing with traditional year-end tax planning, which is basically defer income into next year and accelerate deductions into this year. One exception may be if you expect to be subject to AMT in 2017; then you might want to consider accelerating income to take advantage of the lower (28%) tax rate.

    When it comes to wealth planning, there may be some comfort in getting past the unknown and waiting until early 2018 to implement wealth transfers, unless there is a reason to accelerate a transfer before year end,” adds my colleague, Kelly Cruz, director in strategic planning and principal.

    “Even if a final bill gets passed that includes full estate tax repeal now or in the future, we may still advise moving ahead with lifetime wealth transfer planning if you would have a taxable estate, as we don’t expect a repeal to be permanent,” she says. “The exception would be for much older or unhealthy clients who are more likely to pass during a period of estate tax repeal.”

    Regardless of how tax reform may impact you, it’s always best to meet with your wealth planner to make sure your financial plan, including tax strategies, is positioned to meet your goals into 2018 and beyond.