On December 22, 2017, President Trump signed the 2017 Tax Cuts and Jobs Act (“TCJA”) into law. Many of the changes took place just ten days later, beginning in 2018. Now that several months have passed, allowing tax professionals to digest the changes in this law, let us revisit some of these changes to see how they impact 2018 tax decisions.
As you consider these federal changes, keep a couple of things in mind. First, the speed of crafting the bill and passing it into law just days before it took effect means that the law is in place before we have any official guidance from regulations, notices, publications, procedures, and the like. We are making our best decisions about the “right” and the “wrong” way to implement these rules when the essential fine print is missing. Second, no tax plan is complete without considering state tax, and we have little idea, even five months later, how these rule changes will be accepted or rejected under state tax laws. The states have not been in any hurry to address this matter.
This memorandum is not a comprehensive discussion of the 2017 TCJA but is a highlight of a few key provisions that will impact many taxpayers.
Personal Tax Planning
Overall Itemized Deduction Planning
Under the TCJA, the standard deduction for those married-filing-jointly increases from $12,700 in 2017 to $24,000 in 2018. While the almost doubling of the standard deduction is good news for many taxpayers, some of our clients will find it difficult to itemize deductions going forward. Some deductions are capped, like a $10,000 ceiling on state and local taxes, while others are eliminated entirely, like investment management fees along with all other miscellaneous itemized deductions.
As a general rule, the remaining deductions are primarily these – medical expense, charitable contributions, interest expense, and state and local taxes (these taxes are limited by rule to $10,000 ). For taxpayers in their prime earning years, their medical expenses probably will not pass the deductibility limitations, and their residence may be paid off. If this is your situation, then your remaining deductions are likely taxes (again, limited to $10,000) and charitable contributions. So it’s easy to see that those couples who contribute more than $14,000 a year to charity will be able to itemize and surpass the $24,000 standard deduction, but those who contribute less to charity, even $10,000, may find the standard deduction more beneficial.
For these taxpayers, they should revisit the classic personal tax strategy of “bunching” deductions. Consider the situation of a mature taxpayer couple who does not benefit from itemizing medical expenses. They typically report $15,000 a year of charitable contributions and face the maximum $10,000 of deductible taxes. Their total itemized deductions are $25,000 under the new rules, meaning that they benefit by itemizing by only $1,000. Instead, what if in every even year they paid two years of charitable contributions (“bunching” them), and in the odd years, they skip charitable contributions. In this situation, they would have $40,000 of itemized deductions in the even years and $24,000 of standard deduction in the odd years. Over the two-year period, they would have total deductions of $64,000, which is $14,000 more than their current plan of $25,000 of itemized deductions per year. At the top tax bracket of 37%, this represents tax savings of $5,180.
If the physical act of paying charitable contributions every other year presents logistical challenges, a taxpayer could consider depositing the next year’s contribution in a “donor advised fund”, run by a public charitable foundation. These are offered by many investment houses and by foundations in larger communities. The account functions much like a checking account. The key difference is that contributions are deductible when deposited into the account, and the taxpayer can advise the custodian where payments are to be made to charities in that year or future years.
Qualified Charitable Distributions
Beginning with the year after the taxpayer attains age 70-1/2, these taxpayers are required to withdraw a certain minimum distribution from their regular IRA accounts every year. Roth accounts are exempt from this rule during the owner’s life. For these taxpayers, they can direct that their charitable contributions be paid directly from the IRA to the charity, up to $100,000 per year. While this arrangement does not bring a charitable contribution deduction, it also does not result in IRA income, thus the taxpayer is, in effect, getting a pre-tax deduction. A key benefit after TCJA is that this taxpayer will get a deduction in the form of lower IRA income, even if their personal deduction situation would prevent a tax-deductible itemized deduction, which is more likely under the TCJA’s higher standard deduction. Further, lower IRA income results in lower adjusted gross income and many tax items from deductions to credits are based on adjusted gross income, so further benefits could result.
Equity Line Interest
Under prior law, interest on up to $100,000 of home equity debt was deductible, no matter how the funds were used. Now, after the TCJA, the only deductible home mortgage interest is that which is for the purchase or improvement of a principal or vacation residence.
Thus, if taxpayer borrowed on their home equity line to purchase an auto or other non-qualifying use, they should realize that this interest is not deductible going forward. As discretionary cash is available, paying off the loan for the non-qualifying use should be considered.
Further, if the home equity line was used for both qualifying use (adding a new deck in the backyard) and non-qualifying use (a vacation to Hawaii), then the taxpayer should try to determine the qualifying portion of the loan balance so that the deductible part of the annual interest can be computed.
Business Tax Planning
Employ Your Children
If you own a small business, do you have legitimate tasks that can be performed by your children? If so, are they fairly compensated? With the near-doubling of the standard deduction, an unmarried child can now report up to $12,000 of earnings without paying US income taxes. Don’t forget to consider state taxes and payroll taxes in this analysis.
Meals and Entertainment
Before 2018, business meals and entertainment were both 50% deductible. Certain categories of meals were 100% deductible, like the cost of a company picnic or holiday party. Under this system, the difference between meals and entertainment was not terribly important. In fact, many clients would have a combined expenses account for “meals and entertainment.”
Now, after 2017, the TCJA provides that entertainment is not deductible while meals remain 50% deductible. This means that a broad “meals and entertainment” account is not helpful since tax compliance will require knowing the separate balance of each of these types of expenses.
Also, it is not important to know if an expenditure is for meals or is for entertainment. Consider, for example, taking a key customer to a football game. The costs include travel, parking, tickets, and food. Does the cost of the food need to be separated from the other costs? Is the travel and/or parking pro-rated between the food versus football ticket activities? Does the fact that food is served mean that it’s all really a meal, and the tickets are part of the 50% deductible meal cost? These are questions that the Service will need to answer before 2018 tax returns are prepared.
In the meantime, taxpayers should separate meals versus entertainment in their expense ledgers, and be prepared to identify these combined activities for further discussion.
Re-consider Your Choice of Business Entity
The new TCJA includes many changes which should cause you to re-think your choice of business entity. While we believe that flow-through entities are generally preferential and that taxpayers are not likely to make such a major change based on this law, it may be worth re-examining the situation.
“S” corporations might be better off as a “C” corporation since the top “C” corporation rate was reduced from 35% to 21%. Further, if a “C” corporation could qualify to exclude the gain on the sale of stock under Section 1202, then the prospect of operating a business at 21% income tax, plus the possibility of selling the corporate stock tax-free, can be a particularly appealing combination. Keep in mind that this is a rather tall order with many requirements (must be in certain types of businesses, must follow a very long holding period requirement, must be original issue stock, and among other tests, must be disposed of in a stock sale – when few buyers are willing to buy stock in acquiring a business).
On the other hand, “C” corporations might be better off as an “S” corporation after the enactment of the new Section 199A Qualified Business Income deduction. These “S” corporations might further want to sketch out how the deduction is expected to work for them in 2018 to see if the overall level of compensation expense looks appropriate. An additional consideration is the form of paying taxes on operating profits. Some “S” corporations pay some or all of their income tax via a compensation bonus to shareholder/employees at the end of the year. With the advent of the Section 199A deduction, this plan may not make sense going forward, as profits paid out as compensation is not eligible for this deduction.
Similarly, LLCs or partnerships that pay significant cash guaranteed payments should reconsider this arrangement. This structure will not maximize the Section 199A deduction that could be generated.
If your business is not eligible for the new Section 199A deduction, does a related partnership or LLC own the corporate real estate and collect rents from the business? If so, consider whether the level of related party rent is appropriate, because the rental activity should be eligible for this deduction.
All of these concepts are beyond the scope of this memorandum, and we encourage you to have a conversation with us about these issues.
Section 263A Deduction
If your business is currently dealing with the compliance with Section 263A rules, note that there is some relief to be found in the TCJA.
Previously, resellers with more than $10 million of gross receipts, or manufacturers with more than $200,000 of total indirect costs were required to comply with this rule, which had the effect of delaying the deduction for some expenditures.
After the TCJA, businesses in 2018 up to $25 million of gross receipts will be exempt from these rules, whether a reseller or a manufacturer. For those businesses with more than $10 million of gross receipts but less than $25 million, there will be an opportunity in 2018 to withdraw from Section 263A compliance. The net effect will be a deduction in 2018 for the expenses that have been deferred from prior years – a nice windfall in 2018.
Limited Interest Expense
Beginning in 2018, businesses with over $25 million of average annual gross receipts will face a limitation in interest expense. The deduction is limited to the sum of (1) business interest income, (2) floorplan financing interest, and (3) 30% of adjusted taxable income. Adjusted taxable income is basically business income, without business interest income, after adding back any net operating loss, deductions for amortization and depreciation, and any Section 199A deduction claimed.
If you believe that your business may have to face the suspension of an interest deduction under this rule, please discuss with us so that we can explore this issue and determine what planning. Note that for farmers and certain real property businesses, an election is available to bypass this limitation.
Unreimbursed Employee Business Expenses
If your sales or other employees face significant employee business expenses, consider whether another compensation structure which includes some expense reimbursement would make sense. These deductions are no longer allowed after the TCJA for the employee. Can the business pay it under some restructured arrangement in a way that mutually beneficial for both the employee and the employer?
Feel free to contact us if you want to further explore how these issues impact your tax situation or have other questions about this new law, or other tax questions.