The first step in Tax Reform was announced late last week. This is just a starting point in the process. There are some significant changes ahead but the initial changes announced are far from being finalized. The House Ways and Means committee is currently marking up the initial bill that is summarized below. The Senate will come out with its version later this week. We will compare the two plans to see what is similar in both plans which typically gives us a very good idea what will be in final legislation. It appears the legislation will be effective in 2018. So year end planning will be critical this year. Reach out to your Somerset advisor with any questions or concerns. Stay tuned as more updates will be forthcoming from us as the amendments to the legislation take place.
Changes to Tax Rates & Brackets
- The Act would reduce the number of tax brackets (ranging from 10% to 39.6%) from seven to four: 12%, 25%, 35%, and 39.6%.
- The 39.6% bracket would begin at: $1 million for joint returns/surviving spouses (39.6% rate starts at $470,700 for 2017)
- The 39.6% 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: 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. Single and head of household may actually pay more federal tax in 2018 on $1,000,000 due to the phase in of the lower brackets in 2018 compared to 2017.
Increased Standard Deduction & Elimination of Personal Exemptions
- $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 several dependent children. However, for 2017 personal exemptions start getting phased out for higher income taxpayers so no tax benefit saved for many higher income taxpayers so 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.
Enhanced Child Tax Credit & New Family Tax Credit
- Child credit is increased to $1,600 in 2018 compared to $1,000 in 2017.
- Refundable child credit would be up to $1,000.
- An additional $300 credit each for taxpayer and spouse filing return.
- 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 $115,000 and $230,000, respectively.
Somerset Observation: The increased child credit of $600 per dependent in addition to the $300 per spouse filing the joint return is a significant benefit to middle class taxpayers. 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 $39,800 before the child and family credit. After utilizing the child and family credit, the federal income tax due would be $32,800. $7,000 of credits would be utilized. That equates to a 14% 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 $10,280 of savings.
Somerset Observation: Using the same facts as above, a joint tax return with four dependent children creates a $7,000 credit. If such a family uses the $24,000 standard deduction, such a family could have ordinary adjusted gross income of $82,333 and pay no federal income tax.
New Maximum Rate on Business Income of Individuals
- 25% “business income” rate. The Act would provide a new maximum rate of 25% on the “business income” of individuals. The Act sets out a formula under which it reduces the tax that would otherwise apply to “qualified business income” in order to achieve this maximum rate.
- Flow thru entities will be able to elect a 70/30 split to treat 30% on such income as income subject to the 25%. The other 70% will be subject to ordinary income tax rates up to the 39.6% rate.
- The “business income” from a passive activity will be 100% taxed at the 25% rate.
Somerset Observation: This provision will not apply to certain personal services businesses such as law, engineering, architecture, accounting and other service driven businesses. There is much to be clarified with this provision. For a taxpayer in the 39.6% tax bracket, this 25% business income rate provides a 14.6% tax savings on every dollar of such income. Since 2013, passive income from pass thru entities has been considered not attractive given the additional 3.8% Medicare tax. Starting in 2018, passive income from pass thru entities is attractive. The 3.8% tax cost is offset by the 25% favorable tax rate rather than the potential 39.6% regular rate. The 14.6 percent rate differential offset by the 3.8% Medicare tax creates a 10.8% tax rate savings for passive income compared to active income in 2018.
Combined Education Credits
- The Act would consolidate three higher education credits under current law—the American Opportunity Tax Credit (AOTC), the Hope Scholarship Credit (HSC), and the Lifetime Learning Credit (LLC)—into an “enhanced” AOTC. The enhanced AOTC would, like the version under current law, provide a 100% tax credit for the first $2,000 of qualifying higher education expenses and a 25% credit for the next $2,000 of such expenses (for a $2,500 maximum). The HSC and LLC would be repealed.
- The Act would limit the AOTC to five years of post-secondary education, with the credit for the fifth year available at half the rate as the first four years, with up to $500 being refundable.
- Section 529 Account distributions. The Act would treat up to $10,000 per year for elementary and high school expenses as “qualified expenses” from Section 529 plans.
Somerset Observation: This provision should simplify the higher education tax credit calculations. However, there are still income limitations that could prevent utilization of this credit. 529 account money being available for elementary and high school education will allow parents to put more money into 529 accounts which can earn tax free income to assist with such private education.
Itemized Deduction Changes
- Mortgage interest deduction retained, but with new limits. The Act would retain the home mortgage interest deduction in its current form—i.e., subject to a $1 million cap—for mortgages that already exist on Nov. 2, 2017, as well as for taxpayers who have entered into a binding written contract before that date to purchase a home. However, for newly purchased homes, the deduction will be limited to $500,000 ($250,000 for a married individual filing separately).
- The Act would also limit taxpayers to one qualified residence.
- State and local property tax deduction retained, but with new limits. The Act would eliminate the deduction for State and local income or sales tax (see below), but would retain the deduction for real property taxes, subject to a $10,000 maximum.
- Repealed deductions
– Personal casualty losses
– State and local income taxes and sales taxes
– Alimony payments
– Moving expenses
– Medical expenses
- Modified rules for charitable contributions
– increase the 50% limitation for cash contributions to public charities and certain private foundations to 60%
– repeal the special rule that provides a charitable deduction of 80% of the amount paid for the right to purchase tickets for athletic events
Somerset Observation: These itemized deduction changes will negatively impact many high income individuals who have large mortgage balances, own two homes, pay large amounts of real estate taxes and state and county income taxes. All taxpayers will be negatively impacted that have alimony payments as part of a divorce or have high medical costs from assisted living and nursing home care.
Retirement Plan Changes
- Roth IRA re-characterization rule repealed. The Act would repeal the current-law provisions which allows an individual to re-characterize a contribution to a traditional IRA as a contribution to a Roth IRA (and vice versa) and may also re-characterize a conversion of a traditional IRA to a Roth IRA.
- Modification of nondiscrimination rules. The Act would amend Code Sec. 401 to allow expanded cross-testing between an employer’s defined benefit and defined contributions for purposes of the nondiscrimination rules, effective as of the date of enactment.
Somerset Observation: The above Roth re-characterization rule should not be a major issue to many taxpayers as the rule has been in place for a while and many taxpayer re-characterizations have already occurred. The modification related to cross testing may provide additional opportunity for employee/owners to put additional money into a qualified retirement plan.
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.
- The Act would repeal the estate and GST taxes such that they do not apply to the estates of decedents dying after Dec. 31, 2023, while still maintaining a beneficiary’s stepped-up basis in estate property.
- The Act would lower the gift tax to a top rate of 35% for gifts made after Dec. 31, 2023, and would retain a basic exclusion amount of $10 million and an annual exclusion amount of $15,000 (for 2018), as indexed for inflation.
Somerset Observation: All of the above provisions are a welcome change for very wealthy 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.
Alternative Minimum Tax 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 wealthly 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.