The Senate has come out with its version of the 2017 Tax Reform Act. This version has some similar provisions to the House bill and some are very different. As we mentioned upon issuing the House summary last week, if a provision is in both the House bill and the Senate bill, the likelihood of passage is good.
You will see in the summaries below that we provide a “Somerset Observation” and a “House Bill Comparison .” The House is scheduled to vote on it’s bill on Thursday. The Senate will deliberate and hopefully vote on it’s bill sometime next week. There are still many differences to iron out. In order for the bill to be passed under the reconciliation procedure, the deficit aspect of the bill cannot exceed $1.5 trillion. The importance of the reconciliation procedure is that a majority vote prevails in the Senate rather than the typical 60 vote requirement.
Once both houses have passed their versions, the two bills go to the Joint Committee on Taxation to iron out the differences to create the final legislation. The Republicans are under tremendous pressure to pass the Tax reform before the end of the year. There have been comments made by the President as well as Republican members of Congress that the final legislation will be signed before the end of the year. Time will tell and we will be following it closely so stay tuned.
Individual Taxpayer Proposed Changes Starting in 2018
Changes to Tax Rates & Brackets
- The Act would have seven tax brackets (ranging from 10% to 38.5%): 10%, 12%, 22.5%, 25%, 32.5%, 35%, and 38.5%.
- The 38.5% bracket would begin at: $1 million for joint returns/surviving spouses (39.6% rate starts at $470,700 for 2017)
- The 38.5% bracket would begin at: $500,000 for single and head of household (39.6% rate starts at $418,400 for 2017 for a single and $444,500 for head of household)
Somerset Observation: A 4.6% differential in 2018 for the difference between the $1,000,000 and the $470,700 creates $24,348 of federal tax savings in 2018 compared to 2017 for a joint filer/surviving spouse with taxable income of $1,000,000. Only $3,754 of tax savings for single and $2,553 for head of household.
House Bill Comparison: House bill only contains 4 brackets (12%,25%,35%,39.6%). The Senate Bill maxes out at 38.5%, therefore, the Senate bill provides a 1.1% savings for joint filers with taxable income over $1,000,000 compared to the House bill and over $500,000 for Single and Head-of-Household filers.
Increased Standard Deduction & Elimination of Personal Exemptions
- Standard Deduction increase to $24,000 for joint filers ($12,700 for 2017) and $12,000 for single filers ($6,350 for 2017).
- Elimination of personal exemptions in 2018. Compared to $4,150 for 2017.
Somerset Observation: The increase in the standard deduction benefit seems to be offset by the loss of personal exemptions, especially if the taxpayers have several dependent children. However, for 2017, personal exemptions start getting phased out for higher income taxpayers so no tax benefit is saved for many higher income taxpayers. The exemption repeal is not a significant loss in benefits. However, high income taxpayers typically itemize deductions, thus the standard deduction increase does not provide a benefit for high income taxpayers. For middle and low-income taxpayers, the above changes may benefit or hurt such taxpayers’ dependent upon facts and circumstances.
House Bill Comparison: Very similar to the House bill.
Enhanced Child Tax Credit & New Family Tax Credit
- Child credit is increased to $1,650 in 2018 compared to $1,000 in 2017. A $500 non-refundable credit for qualifying dependents other than qualifying children.
- The age limit for a qualifying child would be increased by one year, so that a taxpayer could claim the credit for any qualifying child under the age of 18.
- The refundable child credit is $1,000 and is indexed for inflation after 2017.
- Phase-out – The Act would also increase the income levels at which the credit phases out. Under current law, the credit is phased out beginning at income levels of $75,000 for single filers and $110,000 for joint filers. The Act would raise these amounts to $500,000 and $1,000,000, respectively.
Somerset Observation: The child credit is increased by $650 per dependent. Note that the 2018 phase out amounts are significantly higher than 2017. For example, in 2018, a joint tax return with $230,000 of ordinary adjusted gross income, who use the new $24,000 standard deduction and has four dependent children would owe federal income tax of $39,992 before the child and family credit. After utilizing the child and family credit, the federal income tax due would be $33,392. $6,600 of credits would be utilized. That equates to a 14.5% effective tax rate on family adjusted gross income of $230,000. In 2017, the same taxpayer would owe federal tax of $43,080 with no child credit available. That amounts to $9,688 of savings.
House Bill Comparison: Similar to the House bill, Senate bill gives an extra $50 of credit per child but does now allow a credit for a taxpayer and their spouse. The House bill allows of $300 each, total $600. The biggest difference is in the phase out amounts. The Senate bill is much more generous by not phasing out the child credit until income reaches much higher levels. Therefore, the Senate bill will allow many more taxpayers to qualify for the credits.
Deduction from Certain Pass-Through Income
- An individual taxpayer may deduct 17.4% of domestic qualified business income from a partnership, S Corporation or sole proprietorship.
- The amount of the deduction is limited to 50% of the W-2 wages of the taxpayer.
Somerset Observation: This provision is very favorable to pass-through entity owners in that owners do not pay income tax on 17.4% of his/her flow-thru income from a flow-through activity. To prevent pass-thru owners from reducing wages/guaranteed payments to take advantage of the 17.4% deduction, the Senate bill only allows the deduction to the extent of 50% of the wages from the S-Corporation or partnership. This provision will require significant planning to try to maximize the deduction while paying reasonable compensation to the pass through owner/employee. The 17.4% deduction would not apply to professional services flow through entities such as law, accounting, architecture, engineering or medical.
House Bill Comparison: House Bill provision is very different. An example: $1,000,000 of flow-through taxable income after wages deduction to employee/owners of $350,000. House Bill federal income tax paid by owners on the $1,000,000 of flow-thru income assuming all owners in the top tax bracket of 39.6% is $352,200 (35.22% effective rate). Senate Bill federal income tax paid by owners on the $1,000,000 of flow-thru income, assuming all owners are in the top tax bracket of 38.5%, is $318,010 (31.80 effective rate). A tax savings to the owners as a group of $34,190 under the senate bill.
Caveat: Dependent upon tax brackets of owners as well as W-2 compensation or guaranteed payments made to owners, the House bill version could be more attractive. Proper planning will be critical regardless of which version survives as final legislation.
Loss Limitations for Non-Corporate Taxpayers
- Excess business losses for taxpayers other than C-Corporations would not be allowed for the tax year but instead would be carried forward to the next year as part of a net operating loss (NOL) carryforward in the subsequent tax year. NOLs utilized will only be allowed up to 90% of taxable income determined without regard to the NOL in the subsequent years.
- An excess business loss for the tax year would be the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a taxable year would be $500,000 for married individuals filing jointly, and $250,000 for other individuals, with both amounts indexed for inflation.
- In the case of a partnership or S corporation, the proposal would apply at the partner or shareholder level. Each partner’s or S corporation shareholder’s share of items of income, gain, deduction, or loss of the partnership or S corporation would be taken into account in applying the above limitation for the tax year of the partner or S corporation
Somerset Observation: An example: 2018 flow-through losses to an individual taxpayer of $800,000 flow thru income $500,000 Schedule C loss of $100,000. On a joint return, taxpayer would be able to deduct the net loss from the above of $400,000 because that net loss is below the $500,000 threshold. However, if the taxpayer was a single filer, the net loss deductible would only be $250,000; the threshold amount. The other $150,000 would be an NOL carryforward to 2019. Plus, the $150,000 NOL can only offset up to 90% of taxable income in subsequent years.
Caveat: This is a troubling provision for flow-thru entity owners and sole proprietors that have large loss years. Under current law, as long as an owner was active in the business and had enough stock/equity basis, a loss of any size could be deductible against other types of income such as wages, interest, dividends, and capital gain income. If this provision ends up in final legislation, losses of businesses will have to be monitored closely and proper planning performed to maximize loss utilization without creating an NOL carryforward.
House Bill Comparison: There is no such provision in the House bill.
Itemized Deduction changes
- The Act repeals the deduction for interest on home equity indebtedness.
- The Act would eliminate the deduction for State and local income tax, sales tax, and property taxes unless incurred as part of a trade or business.
- The Act repeals the overall limitation on itemized deductions.
- Repealed deductions
All miscellaneous itemized deductions that are subject to the 2% floor under current law
Personal casualty losses, except for personal casualty loss incurred in a Presidentially-declared disaster
- Modified rules for charitable contributions increase the 50% limitation for cash contributions to public charities and certain private foundations to 60%
Somerset Observation: These itemized deduction changes will negatively impact many high income individuals who have large mortgage balances, pay large amounts of real estate taxes and state and county income taxes.
House Bill Comparison: Similar provision to the House bill except for the following; 1) House Bill limits interest deduction to $500,000 of debt for newly purchased home rather than the $1,000,000 under the Senate bill and the House bill does not allow interest expense on a 2nd home, 2) House bill allows up to $10,000 of deduction for real property taxes rather than complete repeal under Senate bill, 3) Senate bill retains medical expense deductions, and 4) Alimony payment deduction
Modification of Exclusion of Gain from Sale of a Principal Residence
- The act extends the length of time a taxpayer must own and use a residence to qualify for this exclusion. The taxpayer must own and use the residence as a principal residence for at least five of the eight years ending on the date of the sale or exchange. The previous rule was two out of five years.
Somerset Observation: This proposal now makes it more difficult to exclude the gain from the sale of a principal residence. It increases the amount of time that a taxpayer has to live in the personal residence by three years.
House Bill Comparison: Very similar to House bill
Estate & Generation-Skipping Transfer Tax changes
- The Act would double the base exclusion amount under Code Sec. 2010 of $5 million (as indexed for inflation; $5.6 million for 2018 per taxpayer) to $10 million, effective for tax years beginning after Dec. 31, 2017.
Somerset Observation: All of the above provisions are a welcome change for very wealth taxpayers who want to pass on their family wealth to kids and Grandkids. The change effectively allows a husband and wife to pass on $20,000,000 of assets to their beneficiaries without federal estate tax ramifications.
House Bill Comparison: Similar to House bill except House bill completely repeals the estate tax for decedents dying after December 31, 2023.
Alternative Minimum Tax (AMT) Repeal
- The Act would repeal the AMT, generally effective for tax years beginning after Dec. 31, 2017.
- If a taxpayer has AMT credit carryforwards, the Act would allow the taxpayer to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020, and 2021, with the remainder claimed in the tax year beginning in 2022.
Somerset Observation: The AMT repeal is a welcome relief for many middle income and high income taxpayers making less the $1,000,000 a year. The AMT no longer addresses the tax issues for which it was created many years ago. The AMT was created to make sure the super wealthy paid some amount of income tax. Now the super wealthy do not pay the AMT, but high and middle income taxpayers are subjected to it.
House Bill Comparison: Very similar to House Bill.