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