The long-awaited Republican tax bill—named the Tax Cuts and Jobs Act (the Act)—has finally been unveiled, and while negotiations over the legislation’s contents are set to continue over the coming weeks, the extremely detailed bill provides some key takeaways that taxpayers can consider in the meantime.
The Act does contain a few twists—especially with respect to popular itemized deductions and small-business taxation. This article explores the Act’s provisions and how they differ from the original framework to provide insight for clients as they prepare for the final legislation that the negotiation process will generate.
Individual Income Tax Structure
The Act aims to compress the number of individual income tax brackets from seven to four—the rates proposed in the Act include four brackets (12%, 25%, 35% and 39.6%). Importantly, the Act finally outlines to whom these rates would apply. The highest income tax rate would apply to married taxpayers filing jointly who earn above $1 million annually ($500,000 for individuals).
The standard deduction would be roughly doubled to $24,400 for married taxpayers filing jointly and $12,200 for single taxpayers. The standard deduction for dependents would be limited and the currently existing additional standard deductions for the elderly and the blind would be eliminated.
(Related: GOP Tax Plan Spares 401(k)s, Targets IRAs)
In order to mitigate the potential tax hike caused by eliminating the personal exemption for families, the Act would increase the (refundable) child tax credit to $1,600 (from $1,000) per child under age 17 and create a $300 credit for parents and other non-child dependents.
Also as expected, the Act proposes a complete elimination of the alternative minimum tax (AMT). Some education-related tax benefits (such as the American Opportunity credit) will also remain with minor changes.
The Fate of Itemized Deductions
The Act repeals the deduction for state and local income and sales taxes, but allows a deduction for property taxes that is capped at $10,000. Limiting this deduction to only property taxes could have a substantial impact on taxpayers who live in states with high state and local taxes.
The Act limits the mortgage interest deduction to home loans that are under $500,000—the current cap is $1 million, although current mortgages would be “grandfathered” in and therefore not impacted.
On a related note, the Act would change the rules that govern the current exclusion for gain on the sale of a principal residence, increasing the required ownership and use periods and phasing the deduction out based on adjusted gross income (AGI) above $250,000 for single taxpayers and $500,000 for married taxpayers.
As expected, the Act would eliminate the medical expense deduction entirely. Clients who are not yet eligible for Medicare may wish to consider an HSA strategy or Roth conversion to mitigate the tax impact that eliminating this deduction could create.
Other popular deductions that the Act would eliminate include the deductions for student loan interest and for casualty and theft losses.
Widely expected provisions that would cap pre-tax contributions to 401(k)s and IRAs were not included, but the Act proposes eliminating the current rule that allows taxpayers who execute Roth conversions to “recharacterize” (or undo) the conversion before October 15 of the following tax year.
The Act would also modify the rules governing hardship distributions to eliminate the restriction on making additional contributions to the retirement account within the six-month period following the hardship distribution. It also details the types of contributions that could be withdrawn as hardship distributions.
Further, the 60-day rollover requirement would no longer apply to certain plan loan offset amounts (amounts treated as a distribution either because the plan was terminated while a client’s plan loan was outstanding or because the client failed to make the required installment payments).
The bill would also eliminate IRC Section 409A, which imposes certain requirements on deferred compensation plans, and impose nondiscrimination rules designed to make it easier for plans to provide benefits to older clients.
The Act would lower the maximum tax rate for sole proprietorships, partnerships and S corporations (pass-through entities) to 25 percent (the current structure taxes pass-through income at the owners’ ordinary income tax rates of up to 39.6 percent). Some businesses that offer professional services as their primary business are excluded from this reduction (i.e., lawyers, doctors and accountants).
Detailed rules governing which types of income qualify for the reduced rate are included in the Act in order to prevent higher income taxpayers from taking advantage of the lower 25 percent rate by characterizing more pass-through income as business income (i.e., by lowering the owners’ compensation). However, it should be noted that business owners who are treated as “passive”—i.e., they do not materially participate in the business—would be taxed at 25 percent on all of the business’ income.
Corporations and Expensing Rules
The Act proposes lowering the corporate tax rate from 35 percent to 20 percent (25 percent for personal service corporations). The reduction to 20 percent would be permanent and immediate (rather than phased-in, as many expected could be the case).
Further, the 100 percent expensing rules would apply through January 1, 2023, and increases the dollar value of property that would be eligible for immediate expensing. Many business-related credits (such as the employer-provided child care credit, the work opportunity credit and the rehabilitation credit) would be eliminated under the Act.
The Act would eliminate the current ability of business owners to engage in tax-free exchanges of property that is used in a trade or business (or held for investment). Instead, the Section 1031 rule would be modified so that it only applies to real property exchanges.
Transfer Tax Effect
The Act maintains the estate and GST taxes until 2024. In the meantime, the estate tax exemption would be doubled, allowing clients to shield more assets without the need for complicated planning strategies. However, the Act unexpectedly does not repeal the current “step-up” in basis that applies to property transferred at death.
Lifetime gifts made after 2023 would be subject to the expanded $10 million lifetime exemption amount. In the meantime, the top gift tax rate would be reduced to 35 percent, which would apply to lifetime gifts valued at over $500,000.
The Ways and Means Committee plans to start evaluating the Act on Monday, with the aim of a vote by Thanksgiving — although taxpayers should stay tuned, as much could change in the meantime.
— Related: GOP Tax Plan Spares 401(k)s, Targets IRAs