Overview of the Tax Cuts and Jobs Act of 2017

Bill Gust is a Senior Tax Partner with Gentry Locke. For more than 30 years, Bill has worked with closely held business owners relative to tax, employee benefits, corporate, and sophisticated estate planning matters. With his expertise in implementing business succession strategies, Bill has assisted in the successful transition of many privately held businesses, through sales, mergers and implementation of numerous ESOPs.

The Tax Cuts and Jobs Act (the “Act”) will bring significant changes to many areas of the tax law affecting individuals and businesses beginning January 2018 through 2025. In 2026, the pre-Act rules are scheduled to come back into effect.

This article is a very general overview of just some of the changes that may be of interest, with individual taxation changes presented first, followed by corporate taxation changes. Please note that as the IRS continues its work on the implementation of the Act, we anticipate that additional technical corrections and updated regulations will follow.

Individual Taxation Changes

Rate changes for individuals. Individuals are subject to income tax on “ordinary income,” such as compensation, and most retirement and interest income, at increasing rates that apply to different ranges of income depending on their filing status (single; married filing jointly, including surviving spouse; married filing separately; and head of household). In 2017, those rates were 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.

Beginning with the 2018 tax year and continuing through 2025, there will still be seven tax brackets for individuals, but their percentage rates will change to: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Impact of Changes. While these changes will lower rates at many income levels, determining the overall impact on any particular individual or family will depend on a variety of other changes made by the Act, including increases in the standard deduction, loss of personal and dependency exemptions, a dollar limit on itemized deductions for state and local taxes, and changes to the child tax credit and the taxation of a child’s unearned income, known as the “Kiddie Tax.”

Capital gain rates. The Act did not significantly change capital gain rate structure. Three tax brackets apply to net capital gains, including certain kinds of dividends, of individuals and other noncorporate taxpayers: 0% for net capital gain that would be taxed at the 10% or 15% rate if it were ordinary income; 15% for gain that would be taxed above 15% and below 39.6% if it were ordinary income, or 20% for gain that would be taxed at the 39.6% ordinary income rate.

The Act generally keeps the existing rates and breakpoints on net capital gains and qualified dividends. For 2018, the 15% breakpoint is: $77,200 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $51,700 for heads of household, and $38,600 for other unmarried individuals. The 20% breakpoint is $479,000 for joint returns and surviving spouses (half this amount for married taxpayers filing separately), $452,400 for heads of household, and $425,800 for any other individual (other than an estate or trust).

**It is important to note that these new individual income tax rates will not affect your tax on the return you will soon file for 2017. However they will almost immediately affect the amount of your wage withholding and the amount, if any, of estimated tax that you may need to pay for 2018.**

A related change is that the future annual indexing of the rate brackets (and many other tax amounts) for inflation, which helps to prevent “bracket creep” and the erosion of the value of a variety of deductions and credits due solely to inflation, will be done in a way that generally will recognize less inflation than the current method does. While it won’t be very recognizable immediately, over the years this will push some additional income into higher brackets and reduce the value of many tax breaks.

Standard deduction. The Act increases the standard deduction to $24,000 for joint filers, $18,000 for heads of household, and $12,000 for single and married taxpayers filing separately. Given these increases, many taxpayers will no longer have a need to itemize deductions. These figures will be indexed for inflation after 2018.

Child and family tax credit. The Act increases the credit for qualifying children (i.e., children under 17) to $2,000 from $1,000, and increases to $1,400 the refundable portion of the credit. It also introduces a new (nonrefundable) $500 credit for a taxpayer’s dependents who are not qualifying children. The adjusted gross income level at which the credits begin to be phased out has been increased to $200,000 ($400,000 for joint filers).

Miscellaneous itemized deductions. There is no longer a deduction for miscellaneous itemized deductions which were formerly deductible to the extent they exceeded 2 percent of adjusted gross income. This category included items such as tax preparation costs, investment expenses, union dues, and unreimbursed employee expenses.

Medical expenses. Under the Act, for 2017 and thereafter, medical expenses are deductible to the extent they exceed 7.5 percent of adjusted gross income for all taxpayers. Previously, the AGI “floor” was 10% for most taxpayers.

Casualty and theft losses. The itemized deduction for casualty and theft losses has been suspended except for losses incurred in a federally declared disaster.

Overall limitation on itemized deductions. The Act suspends the overall limitation on itemized deductions that formerly applied to taxpayers whose adjusted gross income exceeded specified thresholds. The itemized deductions of such taxpayers were reduced by 3% of the amount by which adjusted gross income exceeded the applicable threshold, but the reduction could not exceed 80% of the total itemized deductions, and certain items were exempt from the limitation.

Moving expenses. The deduction for job-related moving expenses has been eliminated, except for certain military personnel. The exclusion for moving expense reimbursements has also been suspended.

New State and Local Tax Limitations. For tax years 2018 through 2025, the Act limits deductions for taxes paid by individual taxpayers in the following ways:

. . . Limits the aggregate deduction for state and local real property taxes; state and local personal property taxes; state and local, and foreign, income, war profits, and excess profits taxes; and general sales taxes (if elected) for any tax year to $10,000 ($5,000 for marrieds filing separately). However this limit doesn’t apply to: (i) foreign income, war profits, excess profits taxes; (ii) state and local, and foreign, real property taxes; and (iii) state and local personal property taxes if those taxes are paid or accrued in carrying on a trade or business or in an activity engaged in for the production of income.

. . . Completely eliminates the deduction for foreign real property taxes unless they are paid or accrued in carrying on a trade or business or in an activity engaged in for profit.

To prevent avoidance of the $10,000 deduction limit by prepayment in 2017 of future taxes, the Act treats any amount paid in 2017 for a state or local income tax imposed for a tax year beginning in 2018 as paid on the last day of the 2018 tax year. So an individual may not claim an itemized deduction in 2017 on a pre-payment of income tax for a future tax year in order to avoid the $10,000 aggregate limitation. The IRS has also issued guidance indicating that the prepayment of real estate, personal property and other local taxes in 2017 for 2018 unassessed taxes are not deductible in 2017.

Health care “individual mandate.” Starting in 2019, there is no longer a penalty for individuals who fail to obtain minimum essential health coverage.

Exemptions. The Act suspends the deduction for personal exemptions. Thus, starting in 2018, taxpayers can no longer claim personal or dependency exemptions. The rules for withholding income tax on wages will be adjusted to reflect this change, but IRS was given the discretion to leave the withholding unchanged for 2018.

Estate and gift tax exemption. For decedents dying, and gifts made, in 2018, the estate and gift tax exemption has been increased to roughly $11.2 million ($22.4 million for married couples).

Alternative minimum tax (AMT) exemption. The AMT has been retained for individuals but the exemption has been increased to $109,400 for joint filers ($54,700 for married taxpayers filing separately), and $70,300 for unmarried taxpayers. The exemption is phased out for taxpayers with alternative minimum taxable income over $1 million for joint filers, and over $500,000 for all others.

Deduction for Qualified Residential Interest (i.e., interest on your home mortgage). Under the pre-Act rules, you could deduct interest on up to a total of $1 million of mortgage debt used to acquire your principal residence and a second home, (i.e., acquisition debt). For a married taxpayer filing separately, the limit was $500,000. You could also deduct interest on home equity debt, (i.e., other debt secured by the qualifying homes). Qualifying home equity debt was limited to the lesser of $100,000 ($50,000 for a married taxpayer filing separately), or the taxpayer’s equity in the home or homes (the excess of the value of the home over the acquisition debt). The funds obtained via a home equity loan did not have to be used to acquire or improve the homes. So you could use home equity debt to pay for education, travel, health care, etc.

Under the Act, starting in 2018, the limit on qualifying acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately). However, for acquisition debt incurred before Dec. 15, 2017, the higher pre-Act limit applies. The higher pre-Act limit also applies to debt arising from refinancing pre-Dec. 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. This means you can refinance up to $1 million of pre-Dec. 15, 2017 acquisition debt in the future and not be subject to the reduced limitation.

In addition to the home mortgage interest limit, starting in 2018, there is no longer a deduction for interest on home equity debt. This applies regardless of when the home equity debt was incurred. Accordingly, if you are considering incurring home equity debt in the future, you should take this factor into consideration. And if you currently have outstanding home equity debt, be prepared to lose the interest deduction for it, starting in 2018. (You will still be able to deduct it on your 2017 tax return, filed in 2018.)

Beginning in 2026, interest on home equity loans will be deductible again, and the limit on qualifying acquisition debt will be raised back to $1 million ($500,000 for married separate filers).

Tax Impact for Divorce and Alimony Payments. Under divorce agreements and legal separation agreements executed after 2018:
Under the current rules, an individual who pays alimony or separate maintenance may deduct an amount equal to the alimony or separate maintenance payments paid during the year as an “above-the-line” deduction. (i.e., a deduction that a taxpayer need not itemize deductions to claim which is more valuable for the taxpayer than an itemized deduction.) And, under current rules, alimony and separate maintenance payments are taxable to the recipient spouse (includible in that spouse’s gross income).

Under the Act, alimony payments made under divorce agreements and legal separation agreements executed after 2018 no longer qualify for a deduction for alimony for the payer. Furthermore, alimony is not gross income to the recipient. So for divorces and legal separations that are executed (i.e., that come into legal existence due to a court order) after 2018, the alimony-paying spouse won’t be able to deduct the payments, and the alimony-receiving spouse doesn’t include them in gross income or pay federal income tax on them.

The new rules don’t apply to existing divorces and separations. It’s important to emphasize that the current rules continue to apply to already-existing divorces and separations, as well as divorces and separations that are executed before 2019.

Some taxpayers may want the Act rules to apply to their existing divorce or separation. Under a special rule, if taxpayers have an existing (pre-2019) divorce or separation decree, and they have that agreement legally modified, then the new rules don’t apply to that modified decree, unless the modification expressly provides that the Act rules are to apply. There may be situations where applying the Act rules voluntarily is beneficial for the taxpayers, such as a change in the income levels of the alimony payer or the alimony recipient.

Recharacterization of IRA contributions. An individual who makes a contribution to a regular or Roth IRA can recharacterize it as made to the other type of IRA via a trustee-to-trustee transfer before the due date of the return for the contribution year. Under the new law, however, once a contribution to a regular IRA has been converted into a contribution to a Roth IRA, it can no longer be converted back into a contribution to a regular IRA, i.e., a recharacterization cannot be used to “unwind” a Roth conversion. For any conversions made by taxpayers to a Roth IRA during 2017, taxpayers have until Oct. 15, 2018 to unwind the 2017 recharacterization (provided they meet the requirements for an automatic extension of the election period).

Extended rollover period for plan loan offset amounts. If an employee’s loan from his qualified retirement plan, Code Sec. 403(b) plan, or Code Sec. 457(b) plan is treated as distributed from the plan due to the plan’s termination or the employee’s failure to meet the repayment terms due to his separation from service, the employee may roll over the deemed distribution to an eligible retirement plan. The new law allows the rollover to be made any time up to the due date (including extensions) of the employee’s tax return for the year of the deemed distribution. Pre-Act law allowed the employee only 60 days from the date of the distribution.

Length of service awards to public safety volunteers. Under pre-Act law, a plan that only provides length of service awards to bona fide volunteers or their beneficiaries for qualified services performed, is not treated as a deferred compensation plan for Code Sec. 457 purposes. Qualified services are firefighting and prevention services, emergency medical services, and ambulance services, including services performed by dispatchers, mechanics, ambulance drivers, and certified instructors. The new law increases the limit on the aggregate amount of length of service awards that can accrue in a year of service for a bona fide volunteer from $3,000 to $6,000, to be adjusted annually for inflation. For a defined benefit plan, the limit applies to the actuarial present value of the aggregate amount of awards accruing for any year of service.

Qualified disaster distributions taxable over three-year period. Under the new law, a “qualified 2016 disaster distribution” will be included in a taxpayer’s gross income ratably over a three-year period starting with the year it is received, unless the taxpayer elects to have the distribution fully taxed in the year it is received. A “qualified 2016 disaster distribution” is a distribution received from an “eligible retirement plan” in 2016 or 2017 by an individual whose place of abode was in a Presidentially declared disaster area at any time during 2016, and who sustained an economic loss from the disaster. An eligible plan is an IRA, individual retirement annuity, qualified plan, Code Sec. 403(a) qualified annuity plan, Code Sec. 403(d) plan, governmental Code Sec. 457(b) plan, or Code Sec. 403(b) annuity contract. There is a $100,000 aggregate limit on qualifying distributions for these purposes.

Qualified 2016 disaster distributions not subject to 10% early withdrawal penalty. In general, unless an exception applies, withdrawals from qualified plans and IRAs before age 59 and a half are subject to a 10% penalty in addition to regular taxation. Under the new law, a “qualified 2016 disaster distribution,” defined above, will not be subject to the 10% penalty on early withdrawals from qualified plans and IRAs.

Three-year period to recontribute qualified 2016 disaster distributions. In general, eligible distributions from qualified plans and IRAs can be rolled over into eligible plans within 60 days to avoid being taxed. Under the law new, qualified 2016 disaster distributions, defined above, can be recontributed to a qualified plan or IRA in which the taxpayer is a beneficiary up to three years beginning the day after the date of distribution and avoid taxation. A recontribution is treated as a direct trustee-to-trustee rollover.

Period to amend qualified plans and IRAs for new law changes extended. Under the new law, a qualified plan or IRA can be amended for new law changes retroactively any time up to the last day of the first plan year beginning after 2017 without losing its qualified status for actions taken in compliance with the law changes. Thus, e.g., a qualified plan can make a qualified 2016 disaster distribution in 2017 without first amending the plan to allow such a distribution, as long as the amendment is made retroactively before the end of the extension period. For governmental plans, the amendment may be made up to the last day of the first plan year beginning after 2019.

Corporate Taxation Changes

Corporate income tax rate drop. “C” or regular corporations currently are subject to graduated tax rates of 15% for taxable income up to $50,000, 25% (over $50,000 to $75,000), 34% (over $75,000 to $10,000,000), and 35% (over $10,000,000). Personal service corporations pay tax on their entire taxable income at the rate of 35%. (The benefit of lower rate brackets was phased out at higher income levels.)

Beginning with the 2018 tax year, the Act makes the corporate tax rate a flat 21%. It also eliminates the corporate alternative minimum tax.

Tax Reduction for Pass-Through Entities. The Act provides for a new deduction that should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.

The deduction is 20% of your “qualified business income” or QBI from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, (e.g., capital gains or losses, dividends, and interest income unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.

The deduction is taken “below the line,” (i.e., it reduces your taxable income but not your adjusted gross income). But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.

The Act includes provisions (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into QBI eligible for the deduction. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, (i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, (i.e.,$415,000). If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, for example, if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same calculation would apply using the $315,000 threshold, and a $100,000 phase-out range.)

Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, or $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. If your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, similar calculations would apply using the $315,000 threshold, and a $100,000 phase-out range.)

Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.

As you can see from above, the ability to qualify for the new deduction for Pass Through Entities requires a series of rather complicated calculations and the impact will depend upon the facts and circumstances unique to your situation. Fluctuations in income from one year to another may have a positive or negative effect on the application of the deduction.

Bonus depreciation. Before the Act, taxpayers were allowed to deduct in the year that an asset was placed in service 50% of the cost of most new tangible property other than buildings and, with the exception of qualified improvement property, building improvements. Most new computer software was also eligible for the 50% deduction. Because of the deduction in the year placed in service, there was adjustment of the regular depreciation allowed in that year and later years. The “50% bonus depreciation” was to be phased down to 40% for property placed in service in calendar year 2018, 40% in 2019 and 0% in 2020 and afterward. The phase down was to begin a year later for certain private aircraft and long-production period property.

For property placed in service and acquired after Sept. 27, 2017 (with no written binding contract for acquisition in effect on Sept. 27, 2017), the Act has raised the 50% rate to 100%. (Appropriately, 100% bonus depreciation is also called “full expensing” or “100% expensing”.)

Additionally, under the Act the post-Sept. 27, 2017 property eligible for bonus depreciation can be new or used. Also, certain film, television and live theatrical productions are now eligible. On the other hand, the Act excluded from bonus depreciation public utility property and property owned by certain vehicle dealerships.

The 2018/2019/2020 phase down (above) doesn’t apply to post-Sept 27, 2017 property. Instead, 100% depreciation is decreased to 80% for property placed in service in calendar year 2023, 60% in 2024, 40% in 2025, 20% in 2026 and 0% in 2027 and afterward (with phase down beginning a year later for certain private aircraft and long-production period property).

Code Sec. 179 expensing. Before the Act, most smaller taxpayers could elect, on an asset-by-asset basis, to immediately deduct the entire cost of section 179 property up to an annual limit of $500,000 adjusted for inflation. For assets placed in service in tax years that begin in 2018, the scheduled adjusted limit was $520,000. The annual limit was reduced by one dollar for every dollar that the cost of all section 179 property placed in service by the taxpayer during the tax year exceeded a $2 million inflation-adjusted threshold. For assets placed in service in tax years that begin in 2018, the scheduled threshold was $2,070,000.

The Act substitutes as the annual dollar limit $1 million (inflation-adjusted for tax years beginning after 2018) and $2.5 million as the phase down threshold (similarly inflation adjusted).

Before the Act, section 179 property included tangible personal property as well as non-customized computer software. The only buildings or other non-production-process land improvements that qualified did so because the taxpayer elected to treat “qualified real property” as section 179 property, for purposes of both the dollar limit and the phase down threshold. Qualified real property included restaurant buildings and certain improvements to leased space, retail space and restaurant space.

For tax years beginning after 2017, those buildings and improvements are eliminated as types of qualified real property and there is substituted a far broader group of improvements made to any building other than a residential rental building: (1) any building improvement other than elevators, escalators, building enlargements or changes to internal structural framework, and (2) building components that are roofs; heating, ventilation and air conditioning property; fire protection and alarm systems; or security systems.

Also, for tax years beginning after 2017, items (for example, non-affixed appliances) used in connection with residential buildings (but not the buildings or improvements to them) are section 179 property.

Other rules for real property depreciation. If placed in service after 2017, qualified improvement property, in addition to being eligible for bonus depreciation and being newly eligible as section 179 property, has a 15 year depreciation period (rather than the usual 39 year period for non-residential buildings).

Apartment buildings and other residential rental buildings placed in service after 2017 generally continue to be depreciated over a 27.5 period, but should the alternative depreciation system (ADS) apply to a building either under an election or because the building is subject to one of the conditions (for example, tax-exempt financing) that make ADS mandatory, the ADS depreciation period is 30 years instead of the pre-act 40 years.

For tax years beginning after 2017, if a taxpayer in a real property trade or business “elects out” of the Act’s limits on business interest deductions, the taxpayer must depreciate all buildings and qualified improvement property under the ADS.

Vehicles. The Act triples the annual dollar caps on depreciation (and Code Sec. 179 expensing) of passenger automobiles and small vans and trucks. Also, because of the extension of bonus depreciation, the increase, for vehicles allowed bonus depreciation, of $8,000 in the otherwise-applicable first year cap is extended through 2026 (with no phase-down).

Computers and peripheral equipment. Under the Act, computer or peripheral equipment placed in service after 2017 isn’t treated as “listed property” whether or not used in a business establishment (or home office) and whether or not, in the case of an employee, the use is for employer convenience. So an item no longer has to pass a more-than-50%-qualified-business-use test to be eligible for Code Sec. 179 expensing and to avoid mandatory use of the ADS.

Farm property. For items placed in service after 2017, the Act shortens the depreciation period for most farming equipment and machinery from seven years to five and allows many types of farm property to be depreciated under the 200% (instead of 150%) declining balance method.

As you will note, the foregoing tax changes may present an opportunity for substantial savings. If you have any questions about a specific provision that may affect your business or individual tax situation please feel free to contact Bill Gust or other Gentry Locke Tax attorneys.

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These articles are provided for general informational purposes only and are marketing publications of Gentry Locke. They do not constitute legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult your own lawyer concerning your situation and specific legal questions you may have.