“Don't tax you, don't tax me, tax that fellow behind the tree,” quipped Senator Russell Long, who chaired the powerful Senate Finance Committee from 1966 to 1981.
This past year, Halloween was barely over when House Republicans introduced their version of tax reform. Few observers thought such a massive undertaking could be signed into law within seven short weeks.
But that is exactly what happened. In the hectic days that preceded Christmas, the president signed into law the most sweeping change in the tax code since 1986.
“The legislation will result in substantive tax reform for corporations, with the elimination of the corporate alternative minimum tax (AMT) and consolidation down to a single 21% tax rate (from 35%), all of which are permanent,” Michael Kitces, a respected authority on tax issues, wrote on Kitces.com.
“However,” he added, “When it comes to individuals, the new legislation is more of a series of cuts and tweaks, which arguably introduce more tax planning complexity for many, and will be subject to another infamous sunset provision after the year 2025.”
Sharpen your pencils – the new tax code and tax planning
Over 80% of Americans will get a tax cut next year, while just 5% of taxpayers are expected to pay more (Tax Policy Center, Washington Post). In most cases, cuts are expected to be modest; however, much will depend on individual circumstances.
Due to the complexities of the new law, I encourage you to speak with your advisory team (accountant, attorney, and financial advisor). Many experts are struggling with the details of the bill, and that’s to be expected this early in the game.
What I would like to do is touch on several highlights. It’s not all-inclusive and not a deep dive, but given the many changes, I believe an overview is in order.
So, let’s get started. (Sources for this review include Kitces.com, the Tax Policy Center and Shenkmanlaw.com.) This applies to tax year 2018.
1. The 10% bracket remains unchanged, while the 15% bracket declines to 12%, the 25% to 22%, the 28% to 24%, the 33% to 32%, the 35% holds steady, and the 39.6% slips to 37%. The thresholds are modestly adjusted above the new 22% bracket.
2. The standard deduction nearly doubles to $12,000 for single filers and $24,000 for married filers, reducing the incentive to itemize and simplifying for some taxpayers.
3. The $4,150 personal exemption is eliminated, and the $1,000 child tax credit doubles to $2,000. In general, rules for charitable contributions remain unchanged.
By itself, the combination of points one, two, and three will provide modest tax relief for most families. But I must caution, it depends on your individual circumstances.
4. The increased standard deduction paired with the $10,000 cap on state, local and real estate tax will eliminate the need for many families to itemize deductions. The downside is that charitable gifts are an itemized deduction, and therefore those who take the standard deduction will not receive a tax benefit for their charitable gifts.
The planning opportunity that arises here is to bunch several years’ worth of charitable gifts into one year and itemize deductions in that calendar year. For the ensuring years, use the standard deduction.
For example, assume you and your spouse have itemized deductions totaling $20,000 (of which $4,000 are gifts to charity and $16,000 are mortgage interest and state, local, and real estate taxes). It makes sense for you to take the standard deduction (of $24,000) in 2018 but you lose the deduction for your charitable gifts. Instead, you could bunch several years of charitable gifts, say 5 years or $20,000 of gifts, into one year. You donate cash or stock worth $20,000 to a donor advised fund, receive the full deduction in the 2018 calendar year and distribute those gifts from the donor advised fund to charities over 5 years. In 2018 you’d itemize your deductions (totaling $36,000) and when filing taxes for the following 4 years you’d opt for the standard deduction (of $24,000).
5. Those in high-tax states (NY, NJ, CA, IL, MA, MD) could see the biggest hit, as there will be a $10,000 cap on state, local and property tax deductions.
The $10,000 cap is the same for single filers as it is for married filers. Thus, we now have an increased marriage penalty – an unmarried couple could have $20,000 of combined state, local and property tax deductions (each filing as single to claim the $10,000 cap).
6. For investors, the preferential treatment for long-term capital gains and dividends remains intact.
One important change – the new law repeals rules that allow for recharacterizations of Roth conversions back into traditional IRAs. Once you convert into a Roth, there’s no going back.
7. The 3.8% Medicare surtax on investment income for high-income taxpayers was retained. Since the levy entered the tax code, we have crafted strategies that reduce its bite; however, the tax survived tax reform and is likely to remain a permanent feature of the tax code going forward.
8. The AMT for individuals was not repealed, but exemptions have been widened.
Ideally, it would have been eliminated from the tax code. But Kitces points out, “While the AMT commonly impacted those around $150,000 to $600,000 of income, in the future, AMT exposure will be much smaller, and it will be extremely difficult to be impacted at all, especially given more limited deductions.”
9. The new tax bill also repeals the Obamacare mandate that requires all individuals to obtain health insurance. It becomes effective 2019.
10. The estate tax survived, but the exemption amount will double from $5.6 million to $11.2 million for singles, and from $11.2 million to $22.4 million for married couples. It’s important to note that the gift tax exemption and the estate tax exemption are unified, meaning that married couples can pass $22.4 million dollars to future generations while alive and/or at death.
This deserves some attention. Families whose wealth exceeds the threshold now have more room to gift additional assets to children outright or in trust without triggering gift tax. It also allows these families more room to gift additional assets to grandchildren while avoiding generation skipping transfer tax (GSTT) (allocations of the GSTT exemption must be made accordingly).
For those families under the limits, it’s important to review your existing documents with your attorney. Some wills and trusts contain language that moves an allocation equal to the entire estate tax exemption to an irrevocable trust at the death of the first spouse. This could pose a problem if the intent was to only transfer a portion of estate assets to the irrevocable trust. Remember, it wasn’t that long ago that the estate tax exemption was $1 million where the outcome would have been very different. A $22.4 million exemption will fully exceed most estates.
Finally, it’s important to point out that many of the more popular changes in the tax code for individuals and estates will sunset in 2025 (and could change before then). While many may eventually be made permanent, as we saw with the Bush tax cuts of 2001 and 2003, there’s no guarantee this will happen again. So, this may be a short window of opportunity to transfer wealth down multiple generations.
11. And for businesses: Given that the 21% corporate tax rate applies only to C-corps, there will be a 20% deduction for pass-through entities, such as S-corps, partnerships, and LLCs. Service companies, which were initially thought to be excluded from consideration of the 20% deduction were afforded inclusion in the final bill (in some cases limited qualification based on complex rules). Thus, it’s important to look at each business owner’s situation on a case by case basis.
I am by no means covering the full range of changes in this writing and expect that the rewrite of the tax code will produce unintended benefits and unexpected consequences.
From an economic standpoint, Congress and the president hope to unleash the “animal spirits” that have been lethargic for much of the economic expansion. They hope that changes, especially as they relate to business, will encourage firms to open new plants, expand in the U.S., and level the playing field with the global community.
Prior to reform, the U.S. corporate rate was the third highest among 188 nations (Tax Foundation).
The $64 million-dollar question – will it work? About 90% of economists surveyed by the Wall Street Journal expect a modest boost to growth in 2018 and 2019, but after that, opinions diverge.
If tax incentives boost productivity, it could lift long-run GDP potential, which would yield a significant benefit. If the economic benefits end after a two-year sugar high, it will likely be deemed a failure.
At a minimum, the lower tax rate increases longer-run after-tax earnings, which played a big role in the late-year stock market rally. It could also boost corporate stock buybacks and dividends going forward, which would create an added tailwind for stocks.
More importantly, the new tax law will have specific impacts upon your personal situation, and again I encourage you to meet with your advisory team for guidance in navigating the changes.