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In this article, I look at a topic we have been getting a lot of calls about recently, the newly passed tax reform bill. Getting this bill passed before the end of the year was a major strategic objective for President Trump and the Republican party.
Beyond political considerations, the two major goals of the bill are:
The new rates went into effect on January 1, 2018. According to the non-partisan Tax Policy Center, 80% of taxpayers are projected to experience a tax cut in 2018, with 4.8% seeing a tax increase. We’ll have to wait and see if these figures turn out to be accurate. People in states such as New Jersey, New York, Massachusetts, and California probably won’t be foremost among those changing their minds about the bill due to its limitation on SALT (state and local taxes) deductions. I’ll go over these changes later in this article.
Corporations
The reduction of the corporate tax rate from 35% to 21% is designed to make America more competitive globally as a place to do business, spur corporations to create jobs in the country, and raise wages for existing employees with the tax savings. Bringing the corporate tax rate to a level that is on par with the rest of the world should also cut down on corporate inversions, where American companies relocate overseas to take advantage of lower tax rates abroad. For example, prior to tax reform, both Canada’s current corporate tax rate of 26% and Ireland’s of 12% were significantly lower than the 35% rate applied to U.S. corporations. Tax inversions typically resulted in lost American jobs.
Studies support the contention that the bill will lead to reinvestment in the economy. The National Association of Manufacturer’s Survey for the third quarter of 2017, released September 29, 2017, indicated that tax reform would have a positive effect, with 64.3% of those surveyed saying they would expand their business, 57.3% saying they would hire more workers, and 52.2% saying they would increase employee wages and benefits if tax reform passed.
How the change in the corporate tax rate plays out in reality remains to be seen. There are several variables involved. First, does a corporation have cash on its balance sheet and, if so, is it available to pay raises for expansion. You must look at a company’s working capital to see what will happen going forward. On the strategic level, getting the U.S. tax rate in line with what entities pay in other countries helps keep American companies from looking to move their operations abroad as a way of increasing profits. Another effect of the tax reform should be to spur repatriation of some portion of the $2.5 trillion in unremitted foreign earnings of American companies from the respective countries where the funds currently sit.
There are already signs that tax reform is having an impact, with some small expansions starting, and a number of companies, including FedEx and AT&T, paying out bonuses this year that they hadn’t previously planned on granting. It should be noted that the changes to the corporate tax rate are permanent, unlike the changes to personal tax rates, which will sunset, or revert to pre-tax reform levels, in 7 years.
Pass Through Businesses
Corporations are structured so that first they pay taxes on their earnings and then investors must pay taxes on any dividends paid to them out of those earnings. Pass-through entities, such as a real estate investment trust, an LLC, or S corporation pass their profits through to their owner or owners without a tax bite being taken out first. Businesses which pass through income to be charged at the owner’s tax rate have been granted a 20% deduction by the new law.
However, you should be aware that there are a number of carve-outs that may prevent you from taking advantage of this 20% deduction. Doctors, lawyers, accountants, and financial advisors don’t get the pass-through credit unless their business grosses less than either 160k or 320k, depending on marital status. Generally, businesses that are tied to the person running the business so that someone else can’t simply step in and run the business the same way, such as a doctor’s office, don’t get the pass-through tax break, while businesses that aren’t tied to an individual, such as a manufacturing firm, a retail store, a limo company, etc., do get it.
Since passage, our primary client service has been maxing the tax deduction in 2017 without increasing AMT (Alternative Minimum Tax). We are now focused on what will work best for our clients going forward under the new tax rules. In particular, doctors set up as corporations or other holding companies, and many doctors’ offices and medical practices can’t have non-doctors owning that entity. This presents some limitations for some clients. With expert guidance from the various CPA firms we associate with, Beacon is examining the best vehicles and tax strategies to keep our clients out of the 4.8% of the population that’s going to experience an increase in taxes.
Related: Understanding the Benefits of 529 College Savings Plans
Individuals
The tax reform bill will increase paychecks and take-home pay for most individuals. They say the typical family will get $2,059 in median tax savings, with a doubling of the standard deduction. The top individual tax bracket is lowered from 39.6% to 37%. Various deductions have been eliminated, and personal exemptions have been replaced with a $2,000 partly refundable tax credit.
The tax reform bill limits the amount of itemized deductions you can take. A $10,000 limit has been placed on deductions for state and local taxes and property taxes (known as SALT deductions). The law also reduces the maximum allowable mortgage amount for which interest is tax deductible from $1,000,000 to $750,000. Additionally, interest on home equity loans of any amount is not deductible. Tax reform did not eliminate the estate tax entirely, as some Republicans had hoped, but it does raise the limits on amounts subject to the tax, doubling thresholds to $11 million for individuals and $22 million for couples. The bill repeals the Affordable Care Act’s insurance purchase mandate, removing the penalty for Americans who don’t purchase health insurance. The child tax rate has been increased, while Health Savings Accounts are untouched by the act.
From a planning perspective, the reduction of the highest tax rate, which many of our clients are in, from 39.6% down to 37% may be offset, to some degree, by the reduction in allowable itemized deductions. For people in lower tax brackets, who are on the margin in terms of itemizing their deductions, they may now be able to file a simpler return and save some money on accounting fees.
The SALT limitation of $10,000 is likely to apply to many people living in states with high income taxes and high property states such as New Jersey. For instance, in Bergen County few taxpayers are likely to pay only $10,000 in property tax and/or state income tax, which will be a real challenge at tax time. We are advising our clients, especially those living in high income tax states such as New Jersey, New York, Massachusetts, and California, to take a closer look at their state income taxes and property taxes to see how their tax liability will be affected under the new rules.