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What Tax Reform Means for Advisors and Clients

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The expansive Tax Cuts and Jobs Act (TCJA) involves changes to many types of taxes — individual, corporate, partnership and other “pass-through” business entities, estates and tax-exempt organizations.

While most of the shifts became effective Jan. 1, 2018, tax returns filed during this spring (for the 2017 tax year) generally are not affected, according to H&R Block. But the changes are sweeping for the rest of 2018 and beyond, as most tax filers will be in a new tax bracket and tax rate structure.

To get a sense of what’s most significant in the 1,097-page document for advisors and their clients, Investment Advisor turned to:

Mark Astrinos

Member of the American Institute of CPAs Personal Financial Specialist Credential Committee, founder and principal of Libra Wealth and CFP, CPA, FPS and RLP.

Andy Friedman

Principal and founder of The Washington Update, formerly a senior partner with the law firm of Covington & Burling and tax counsel to the NFL, NBA, MLB and NHL.

James Hickey

Chief investment strategist with HD Vest, formerly with the quant investment firm FDO Partners and the multi-strategy investment firm and family office RiverRock Group.

William F. Wolf

Managing partner of the Encino, California, office of Squar Milner, a CPA and financial advisory firm, as well as an expert witness and court-appointed referee on accounting matters.

What are new tax law’s biggest impacts on advisors and their clients — specifically in investment areas that are being affected directly (like pass-throughs) and family wealth issues (like alimony)?

Friedman: The biggest changes for investors involve the substantially lower tax rate for large corporations (providing a potential boost to earnings and equity values), the lower tax rate for owners of some pass-through businesses, the expansion of 529 plans to include pre-college education expenses, the doubling of the estate tax exemption, and the reduced applicability of the alternative minimum tax. Another major change regards itemized deductions, which I discuss in more detail below.

Hickey: From an investment standpoint, this is a huge win. Newspapers have highlighted the benefits of the 21% corporate tax and lower tax on repatriating overseas earnings. In addition, the top tax rate for investing in REITs and MLPs has dropped from 39% to 29%.

For families of wealth, the lower pass-through tax rate of 29.6% (vs. 37% for regular income) helps them with their private investments and their family-owned businesses. However, the drastic reduction of itemized deductions has a real impact. For example, the cap on mortgage deduction and state and local taxes makes a huge difference for people living in high-tax states like California and New York. Long term, this might lead to population migration.

As for some overlooked changes, the removal of alimony deductions starting with divorce orders in 2019 (and removal of the requirement for the recipient to report alimony income for taxes) might lead to more acrimonious divorces since it makes the payment more expensive for the payer — and payment far more attractive for the recipient. However, one would assume that most divorce courts would adjust the payment for taxes. Please remember, however, this does not impact current alimony agreements.

Wolf: Far and away, the biggest impact is the qualified business income deduction. For investment advisors, QBI will have a broad impact and will dramatically reduce taxes.

A lot of IAs advise clients on private equity. Plus, a lot of forms of investment advisory are publicly traded partnerships, which are pass-through entities and are effectively taxed at a lower rate than other ordinary income in an individual’s return due to the 20% QBI deduction. It’s like we have a special tax bracket of 29.6% instead of 37% for pass-through entities.

This will be dramatic and cause advisors to look at that tax savings and, on balance after tax, look more at private equity and other forms of investments that are in partnerships, such as master limited partnerships, real estate, etc. We’ll likely see more people investing in partnerships and other passive entities rather than in C Corps because [the former] are taxed at a lower bracket.

Astrinos: Under the new Tax Cuts and Jobs Act many clients will no longer itemize their deductions on Schedule A of their tax return; this is primarily because we now have a larger Standard Deduction ($12,000 for individuals and $24,000 for married couples). For those who will still itemize, there have been several cuts to the existing deductions.

For starters, the maximum deduction for state and local income taxes and property taxes paid is capped at a maximum of $10,000. Second, the home mortgage interest deduction is limited to $750,000 of debt, which was previously set to $1,000,000.

Also, all the “miscellaneous itemized deductions” (previously subject to the 2% of adjusted gross income floor) have been removed; this includes tax preparation expenses, unreimbursed employee business expenses, and the deduction for investment advisory fees. The last deduction (investment advisory fees) produces a slight impact to the advisory industry as in the past it was something communicated as an ancillary benefit to clients, which will now go away.

Because everyone’s tax situation is different, it’s difficult to say what the impact will be across the board for all clients; some will benefit and others will be negatively affected. You really need to run a tax projection with 2018 figures to see the impact. If Q4’17 was busy for tax and financial planning professionals, I suspect Q4’18 will be the same as everyone tries to assess the impact of these changes.

This deduction list isn’t meant to be exhaustive, but simply highlights these changes: Alimony will no longer be deductible for any divorce or court ordered payments executed after Dec. 31, 2018. This will certainly affect the negotiations behind closed doors for divorce and family law attorneys.

The 2018 unified estate and gift tax exemptions were doubled from $5.6 million (single) and $11.2 million (married couples) to $11.2 million (single) and $22.4 million (married couples). It’s important to remember that these higher exemption amounts are currently scheduled to sunset on Dec. 31, 2025, meaning that lots of advanced estate planning strategies deployed in the past will continue to be relevant for the ultra-wealthy.

There’s a new deduction against taxable income equal to 20% of Qualified Business Income, which generally means income from pass-through businesses. There are many specific rules and thresholds to determine the amount of the deduction, but this is an area where we’ll see lots of tax planning being done to maximize the allowable deduction.

Also, 529 plans can now be used tax-free for private elementary and secondary school expenses (up to $10,000) per student each tax year, which will be helpful to clients who pay out of pocket.

Finally, the TCJA repealed the rules that previously permitted recharacterizations of Roth conversions, which was a popular planning strategy in the past where clients and their advisors could “undo” conversions that did not perform as expected.

How about capital gains changes that advisors/clients should expect and plan for due to the tax reforms?

Friedman: The capital gains tax rate did not change. Neither did the 3.8% surtax on investment income imposed by the Affordable Care Act. On the plus side, the proposal to tax securities sales on a FIFO basis was not included in the final legislation. I don’t think the law materially affects an advisor’s strategy with respect to acquiring dividend-paying stocks and recognizing capital gains.

Astrinos: Capital gains rules are still how we’ve understood them to be in the past; in other words, nothing has changed with how they’re computed. What’s changed, however, is that the income thresholds, particularly for long-term capital gains, no longer line up with the ordinary income brackets.

For example, if you’re single and incur a capital gain between $38,600-$425,800, you’ll pay 15%. These brackets are no longer lined up with the marginal tax brackets that are now law and still follow the prior tax tables; meaning that clients won’t feel a change. Advisors, on the other hand, will have one more set of numbers to remember or reference during their planning. Short-term capital gains, though, will see more of a change because these are still considered ordinary income and therefore follow the new ordinary income tax brackets.

In summary, investment and tax planning around recognizing capital gains has not changed; when possible advisors and clients will be looking for ways to structure tax efficient portfolios, being sensitive to taxes during re-balancing, and prioritizing which investments should be placed in which accounts according to their tax characteristics.

What other key tax changes will affect financial planning, and why are these changes important?

Friedman: To me, the biggest change — and hence the most exciting new area for tax planning — involves whether clients should incur expenses that potentially are itemized deductions. The law’s doubling of the standard deduction to $24,000 for joint taxpayers is expected to reduce the number of taxpayers who itemize from about one-third to under 10%.

Think of that — over 90% of taxpayers will not be itemizing their deductions. This means that investors should not for tax reasons incur expenses that give rise to itemized deductions unless they are sure those deductions in the aggregate will exceed $24,000.

For instance, we already know, under the new law, that someone buying a home gets no tax benefit from incurring mortgage debt in excess of $750,000. But should they incur even that much debt? At today’s rates, the annual interest due on $750,000 of debt is about $24,000 — the same amount as the standard deduction.

Thus, taking on the debt and incurring that interest expense, standing alone, provides no incremental tax benefit. If the investor has few other itemized deductions, it might make sense to obtain a lower mortgage or even to purchase the house with cash.

Similarly, the 90% of taxpayers who do not itemize get no incremental tax benefit from making charitable contributions. (For this reason, charities are very concerned that the doubling of the standard deduction will adversely affect donations.) It could make sense for taxpayers who otherwise take the standard deduction to “bunch” a number of years’ charitable contributions into a single year, so they can exceed the standard deduction in that year and get a tax benefit from the contributions.

Here a Donor Advised Fund might be useful: The investor could contribute multiple years’ donations to the DAF in a single year, thereby claiming the itemized deduction, and then have the DAF dole out the funds to specified charities over the succeeding years in smaller annual amounts.

Hickey: One of the most problematic changes was removing the client’s ability to take an itemized deduction for financial-planning costs that are more than 2% of adjusted gross income. This punishes retired clients who live off their investment income.

For example, imagine an elderly couple with $1 million in a portfolio. The portfolio generates 8% realized return (or $80,000). The advisor charges 1% AUM, or $10,000. Now, that $10,000 expense is not deductible beyond the first $1,600 (or less depending on the client’s other itemized deductions). The client cannot deduct $8,400 if they itemize, or over 10% of the total return. That makes a huge difference!

It also unfairly discriminates against financial advisors as compared to funds. Fund expenses are still fully deductible for fund managers. Thus, if an advisor builds an investment portfolio for a client, it’s not deductible. However, if the client invests in a fund, the fund expenses are deductible.

Ultimately, this may lead to suboptimal behavior and create a greater public burden. If elderly individuals modify their behavior to DIY because of tax treatment, they will likely invest suboptimally. There are costs to all of us if this happens, because it is more likely they will outlive their saving or not have the savings for a critical need.

The other overlooked change was capping interest deductions for companies at 30% of adjusted income. Long term, this will lead to a delevering of corporations because the tax benefit of leverage is capped. This means less corporate investment grade and high-yield debt will be available. This also means lower yields because of limited supply, and investors will have to pay up for exposure.

Wolf: C Corps’ tax rates are down to 21% from 35% — that’s a 40% decrease and is incredibly dramatic. C corps still are not better if you want to pass out your income, or in other words, distribute income to owners. But if you want to keep income in the business because you want to grow the business, a C Corp might be a better vehicle for the first time in a long time.

Then there’s the loss of state income and property taxes as deductions. In high-tax states like California and New York, most people have state income and property taxes that are more than $10,000, so the deduction doesn’t go very far.

It’s a hot topic in Los Angeles, where I have a lot of clients who are very upset. They think their taxes will go up because they can’t deduct [all their] state income and property taxes anymore. But I tell them, ‘Wait a minute. Before we had the Alternative Minimum Tax, which basically wiped out a lot of benefits of state income/property tax deductions anyway.”

Your taxable income is important. If it’s between approximately $80,000 and $300,000, you’re subject to the AMT more so than other people. But the AMT no longer applies, because the main item that caused AMT was the state income tax deduction. So, the AMT is not a substantial factor anymore.

Who gets hit worse? Generally, people who make more than roughly $400,000 and have a lot of property and state income tax will be hurt with the limited deductibility of those items.

Of course, now there is the standard deduction of $24,000 (married/joint filing). Also, rates come down from a maximum of 39.6% to 37%. Still, on balance, if you make more than approximately $400,000 to $500,000 a year, you’ll likely have a net tax increase.

Astrinos: Because of the changes to tax law, a combination of new and old tax financial planning strategies will become more popular. As mentioned previously, because of the increases to the standard deduction, many households will no longer itemize deductions, which means that tax deductions that were once commonly used in full, such as state and local income taxes, property taxes, mortgage interest, and charitable deductions, may not be utilized.

It’s important to note that just because these deductions may not be utilized does not mean that the client is worse off; the impact on each client will vary. For example, some clients who were above the previous standard deduction but well below the current standard deduction may now benefit from an overall increase in total deductions, which will lower their overall tax liability.

On the other hand, clients who were above the previous standard deduction and still below, but very close to the current standard deduction, may no longer “get credit” for some of their deductions. As a result, we will begin to see a lot more timing strategies focused around grouping deductions together in order to maximize the benefit in any given year, meaning itemizing in some years and taking the standard deductions in others.

Tools such as the use of Donor Advised Funds where clients can control the timing and amount of charitable deduction will become more popular. In addition, previously used planning techniques such as Roth IRA conversions will resurface for those clients who are currently in low tax brackets, but expect to be in a higher one in the future.

What age group of clients will new tax law affect most (pre-retirees/retirees, etc.), and how should advisors optimize/minimize these changes for these clients?

Friedman: The law is likely to affect pre-retirees, that is, people whose annual earnings likely are at the peak. For these people, careful tax planning is necessary to balance the benefit of the slight reduction in tax rates with the new restrictions on, and lower utilization of, itemized deductions.

Investors who are employees presumably should continue to maximize their qualified (deductible) retirement plan contributions. But small business owners eligible for the new pass-through deduction might do better instead to eschew qualified contributions (which will offset income taxed at a lower rate) or to make such contributions to Roth accounts.

Hickey: This impacts all constituencies. For people in their wealth accumulation stages, this means that they might help reach their retirement goals faster. For retirees, this might mean additional wealth or buffer until savings are depleted. For business owners, this might mean transitioning day-to-day ownership to fully take advantage of the new passive rate.

Astrinos: It’s hard to generalize about how the new tax law will impact certain demographics of clients more than others. What I can say is that everyone will be affected, but the magnitude depends on their particular circumstances.

For example, if you are in the accumulation phase of the investment cycle, a high-income earner, and still have many deductions, you’re going to want to do ongoing tax planning to ensure that you’re maximizing deductions on a year-to-year basis. On the other hand, if you’re a retiree in the decumulation phase, low income, and don’t have many deductions, (i.e. maybe you don’t have a mortgage or you have very low property tax basis), then you’re still going to want to do ongoing tax planning to take advantage of opportunities to draw down from your portfolio in the most tax efficient manner and manage your investment portfolio in a way that produces the highest after-tax return. In either case, advisors will be trying to squeeze out every last dollar they can within the constraints, facts and circumstances of each client.

What do you see as long-term effects of this tax law on the economy, as well as on the wealth management business and advisors?

Friedman: Since President Trump first began touting the benefits of a major tax cut, I have been concerned that the resulting stimulus is coming at the wrong time. Adding over $1 trillion of stimulus to an economy so close to full employment runs the risk of rekindling inflation.

If the Fed begins to see signs of inflation, it might raise interest rates faster than it would otherwise. Higher interest rates — forcing businesses to pay more to borrow — would slow down the economy, counteracting the stimulus the tax cuts were intended to provide. I should add that reasonable people can and do disagree with this position, noting in particular that the reduction in tax rates was necessary to help U.S. companies compete globally.

Hickey: This will have a huge impact on the U.S. economy for years to come in terms of accelerating growth. Most publicly, we anticipate roughly $1 trillion being repatriated to the United States from overseas. Part of this will be investing by U.S. companies. In addition, lowering the effective corporate tax rate to 21% will likely mean companies will invest part of the saving into growth opportunities.

Beyond these growth opportunities, this should help drive global interest in investing in the United States. More capital for investment ultimately translates into economic and job growth.

For wealth management and investment management business, this is good news. This makes investing in U.S. equities a potentially more compelling option for the foreseeable future.

Wolf: A huge impact on business is the 100% bonus depreciation, which always has been an incentive to stimulate the economy and to have businesses invest more in capital improvements. But this now is bigger than ever.

Basically, you can write off all your capital expenditures whether you’re a billion-dollar company or a small company. There used to be a cap, but now every company can do this. It should stimulate economy and cause people to invest in capital improvements, because they can write them off and shelter their income.

That, in combination with the C-Corp tax rate being reduced to 21%, is something like a 40% reduction in income taxes, which is mind-boggling. If you’re a publicly traded company, you can write off all capital improvements, which will have a tremendous benefit and should stimulate the economy.

Also, changes in the deductibility of business interest should impact both private and public businesses. You cannot deduct this interest if it exceeds 30% of earnings before interest, taxes, depreciation and amortization (EBITDA).

This business interest deduction limitation probably means M&A transactions will be done differently, with more equity and less debt — which should have a big impact on M&As. All businesses will have to think twice about how much leverage they want, so it will be interesting. This change doesn’t apply to real estate, which can deduct more than 30% of EBITDA. Advisors will need to understand and see how this change impacts M&A activity for clients.

Astrinos: I’ll start off by saying that I’m not an economist, so I cannot predict what the impact of the new tax law will be on the economy. This isn’t the first time we’ve seen an administration enact changes to tax law.

What’s particularly interesting about this change is the surge of interest from the average client, even those who historically weren’t interested in money-related discussions like taxes, investments and the financial markets. It seems like a lot more people have now taken an interest in their own financial health, which I think is great for the consumer because they should play an active role in their finances.

Professionals also will be in the spotlight as there’s heightened awareness around finances and questions arise from consumers. They will need to ensure that they maintain a high standard of care and adapt to the changing needs of consumers.

This won’t be the last time that change affects clients and our industry, so clients and professionals should learn from this experience and put together some best practices to adapt now and into the future. Examples include regular communication, education/training opportunities for the client and professional, and leveraging technology whenever possible.

Overall, what advice would you give advisors in terms of most helping clients and/or working in cooperation with accountants/tax experts given all these reforms?

Friedman: The new tax law was not only sweeping — it was sudden. It serves as a reminder that taxes change, and often without much notice. And that trend will continue: At some point, the Democrats will be back in power and likely will raise tax rates.

Even if that does not happen, most of the changes in the new tax law expire by their terms in 2025, so advisors need to prepare their clients for “tax volatility.” This means having different investments and different accounts that allow a client to modulate taxable income, particularly in retirement, to account for different tax rates.

Advisors should make sure clients have different types of accounts — taxable, tax-deferred — and different types of investments — ordinary income, capital gains/dividends, tax free, tax deferred — so that they can recognize more taxable income when taxes are low and less taxable income when taxes are high.

Hickey: The fundamentals for investing stay the same. This just makes investing in U.S. markets more compelling. As a result, we have slightly tilted our portfolios for more U.S. small-cap and mid-cap exposure because we think these asset classes will outperform.

Investments in individual sectors may be more volatile than investments that diversify across many industry sectors and companies. Certain sectors of the market may expose an investor to more risk than others.

Wolf: Most advisors charge asset management fees of about 1% of assets. Now broker commissions are deductible as an adjustment on the gain of sale of an asset, and advisors’ fees aren’t deductible.

Will we see a trend in which some advisors go back to charging brokerage commissions that are effectively deductible? We may, but there are layers of complexity here. Maybe we’ll see a blend of 50/50 for advisor fees/brokerage commissions.

Astrinos: I’ve said this before and I’ll say it again: The past few months have illustrated the importance of working with a CPA financial planner or tax planner on an ongoing basis to ensure you’re taking advantage of all opportunities to optimize your finances. Also, it goes to show that planning is not a singular event. It’s dynamic, meaning it’s constantly evolving as a result of tax law, financial markets and changes to your personal situation.

I tell my clients that open and regular communication will benefit them because the more I know, the more I can put all the pieces of the puzzle together and perhaps think of creative ways to help them save money. I also think that the changes remind us that everyone should have a financial plan that they use as a flight plan.

It’s understandable that life happens and occasionally people will veer off course, but this is something they should review regularly. When you have a plan in place and know where you’re headed, it’s much easier to take advantage of planning opportunities.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.