Highlights of the Tax Cuts and Jobs Act
By Edward P. Rigby, CPA, The Curchin Group, LLC –
March 9, 2018
This article highlights the key individual and business tax law changes contained in the Tax Cuts and Jobs Act (P.L. 115-97) passed by Congress on December 20, 2017 and signed into law by President Trump on December 22, 2017. Among the major tax law changes are reform of individual tax rates, treatment of business income of individual taxpayers, repeal of individual tax deductions, reduction in the corporate tax rate and increase in deductions for business capital investment.
Reform of Individual Tax Rates and Increase in Standard Deduction
The new law retains seven individual income tax rates: 10, 12, 22, 24, 32, 35 and 37 percent). Under the prior law, for 2017, the top individual income tax rate was 39.6 percent for taxable income over $470,700 for a married couple filing a joint return ($418,400 for single taxpayers). Beginning in 2018, the top 37-percent tax rate applies to taxable income over $600,000 for married joint filers ($500,000 for single taxpayers). The new law generally retains the maximum tax rates on long-term capital gains and qualified dividends (e.g., the 20-percent rate applies to married joint filers with taxable income over $479,000). The new law increases the standard deduction for married couples filing a joint return to $24,000 ($12,000 for single taxpayers). Thus, the new law nearly doubles the standard deduction amounts beginning in 2018.
Deduction for Qualified Business Income
There is a new 20-percent deduction available for individual taxpayers with passthrough income from sole proprietorships, partnerships (including LLCs taxed as partnerships) and S corporations. To qualify, the income must be domestic, non-service business income. Also, there is a limitation or cap on the deduction based on wages paid by the passthrough business and capital investment as follows: The deduction is limited to the greater of: (1) 50 percent of the W-2 wages paid by the passthrough business or (2) 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of depreciable property used in the business. Further, specified service businesses such as accounting, law, healthcare, financial services and brokerage services are not eligible for the deduction (an exception applies for engineering and architectural services allowing such businesses to qualify).
The limitation or cap based on wages and capital is not applied to taxpayers with taxable income below the following thresholds. Further, the restriction on specified service businesses also does not apply to taxpayers with taxable income below these thresholds. For a married couple filing a joint tax return, the taxable income threshold is $315,000 ($157,500 for other filers). Thus, a married joint filer may claim the deduction regardless of W-2 wages and whether the business is a specified service business if their taxable income is below $315,000. The wage and capital limitations and restrictions on service businesses phase-in when taxable income exceeds the $315,000 and $157,500 thresholds. The phase-in ranges are $100,000 for joint filers and $50,000 for other filers. Thus, a married joint filer with taxable income over $415,000 is subject to the wage and capital limitation and must own a non-service business to claim the deduction.
Disallowance of Active Passthrough Losses
Pass-through losses (after the application of passive-activity loss rules) from active trades or businesses are capped at $500,000 for a married joint filer ($250,000 for all others). Losses in excess of these amounts are carried over as part of the taxpayer’s net operating loss (NOL). To illustrate, assume a married joint filer receives a partnership K-1 with a $1,000,000 loss (the loss is not a passive-activity loss). The loss is limited to $500,000 for the current tax year with the excess amount treated as an NOL carryover amount to the subsequent tax year.
Repeal and Limitations on Individual Tax Deductions
The new law repeals the deduction for personal exemptions beginning in 2018. Deductions for state and local taxes that are not incurred in a trade or business are capped at $10,000. Interest on home equity loans are disallowed, and interest on mortgages for acquisition indebtedness are limited to mortgage debt up to $750,000 (subject to grandfather rules for mortgages incurred before December 15, 2017). Further, miscellaneous itemized deductions subject to 2 percent of adjusted gross income (AGI) limitations are repealed. In addition, beginning in 2019, alimony deductions are repealed (and corresponding inclusion in income for the alimony recipient is also repealed).
Estate, Gift and Generation Skipping Transfer (GST) Taxes
The estate, gift and GST exemption amounts are doubled for estates of decedents dying and gifts made after December 31, 2017, and before January 1, 2026. For 2018, the exemption amount is approximately $11.2 million. The new law retains the prior-law concept of basis step up for inherited assets and carryover for gifts. Thus, prior to gifting appreciated assets, a careful analysis should be made of the benefits of obtaining a basis “step up” upon the death of a decedent rather than obtaining a basis carryover from a gift.
Alternative Minimum Tax (AMT)
The new law repeals the AMT tax for corporations. Carryovers of AMT tax credits are retained. The AMT is retained for individual taxpayers with increased exemption amounts and phase-out thresholds. Beginning in 2018, the AMT exemption amount is increased to $109,400 for married joint filers ($70,300 for all other taxpayers). The phase-out thresholds are increased to $1,000,000 for married joint filers ($500,000 for other filers) (under the phase-out rules, the benefits of the AMT exemption are reduced as alternative minimum taxable income exceeds the phase-out thresholds).
Corporate Tax Rate Reduction
Effective for tax years beginning after December 31, 2017, the tax rate for C corporations is reduced from a top rate of 35 percent to a new rate of 21 percent. Under prior law, corporations were subject to a graduated tax rate schedule from 15 percent to a top rate of 35 percent. Under the new tax law, there is a flat rate of 21 percent imposed. Special straddle rules apply for fiscal-year corporations that begin prior to December 31, 2017, and end in 2018. Thus, a fiscal-year corporate taxpayer will calculate their tax using a blended tax rate (based on a calculation that combines the prior law and new law tax rates).
Increased Bonus Depreciation
The new law increases the deduction percentage under “bonus depreciation” for qualified property (from 40 percent in 2018 and 30 percent in 2019 under prior law) to 100 percent for property acquired and placed in service after September 27, 2017, through 2022. After 2022, the percentage of bonus depreciation is phased down through 2026 (80 percent for 2023, 60 percent for 2024, 40 percent for 2025 and 20 percent for 2026). The new law allows used property to qualify for bonus depreciation (prior law contained an original use test). Qualified property generally includes tangible property such as machinery and equipment and also includes certain qualified improvement property (i.e., improvements to interior portions of nonresidential real property).
Increase in Expensing Election Under Code Section 179
The dollar limitation on Section 179 deductions is increased from $500,000 under prior law to $1 million for tax years beginning after December 31, 2017. Section 179 allows a taxpayer to make an election to depreciate the cost of qualified property in the year that the property is placed in service rather than claiming depreciation over the applicable MACRS depreciation life. The Section 179 phase-out is also raised from $2 million to $2.5 million. The phase-out reduces the maximum $1 million deduction when the cost of Section 179 property acquired during the tax year exceeds $2.5 million. Other limitations such as the taxable income limitation and application of the deduction for owners of passthrough entities such as partnerships and S corporations are retained under the new law. Under the new law, certain qualified improvements to real property such as roofs, air conditioning and heating systems, and security systems that are improvements to nonresidential real property qualify for Section 179 expensing.
Net Operating Losses (NOLs)
Prior law allowed a two-year carryback of NOLs and a 20-year limitation on NOL carryforwards. For regular tax purposes, a taxpayer’s NOL could be offset against 100 percent of taxable income. Under the new law, carrybacks of NOLs are repealed. There is an indefinite carryforward of NOLs, and the amount of taxable income that can be sheltered by the NOL is limited to 80 percent of taxable income.
Reform and Simplify Small Business Accounting Methods
The requirement for C corporations to use the accrual method of accounting was based on a $5 million gross-receipts test. Under the new law, the gross-receipts test is raised to $25 million. The $25 million gross-receipts test is also used for purposes of determining whether a taxpayer is subject to capitalization of inventory costs under Code Section 263A. Further, the small business exception for long-term contracts and required use of percentage of completion method has been raised from $10 million to $25 million.
Limitation on Deduction of Net Business Interest Expense
Net business interest expense deductions are limited under the new law to 30 percent of adjusted taxable income. Real estate businesses can elect out of the interest expense limitation rule (electing out of the limitation rule requires a longer depreciation life for real property). Small taxpayers meeting the $25 million and under gross receipts test discussed above for small business are exempt from the interest expense limitation rule.
Other Business Tax Provisions
Beginning in 2018 (subject to certain grandfather rules), deferred or “like-kind exchanges” under Code Section 1031 are limited to exchanges of real property. Prior law allowed deferred exchanges for tangible personal property such as artwork or machinery and equipment used in the taxpayer’s business. The prior law deduction for domestic production activities has been repealed. Further, deductions for business entertainment expenses such as golf and sporting events are disallowed beginning in 2018.
Sunset Rules Apply to Individual Tax Reform
The individual tax law provisions discussed above such as the reform of individual tax rates, special pass-through deduction for individuals, repeal of individual tax deductions and personal exemptions, increases to the estate, gift and GST exemption amounts and individual AMT changes are subject to a sunset provision for tax years ending after December 21, 2025.