On December 20, 2017, the Tax Cuts and Jobs Act (the “Act”) was passed by both houses of Congress, and will be signed into law by the President. The Act is the first major overhaul of the Internal Revenue Code since 1986 and presents a major shift in the way business organizations are taxed. This article will provide a high-level overview of major changes contained in the Act. Unless otherwise noted, the provisions of the Act will take effect January 1, 2018.
1. C Corp Tax Rate
Under current law, C corporations pay an entity-level income tax of up to 35% and a second level tax is assessed on dividends distributed by those corporations of up to 20%. This two-tiered taxation is known as double taxation. The Act changes the income tax rate on C corporations to 21%. This is an attempt by Congress to normalize the taxation of C corporations with other pass-through entities such as S corps and partnerships, which are discussed below.
This change in the taxation of C corporations presents certain planning opportunities. For instance, since the corporation pays the lowest possible income tax rate of 21% when it’s earned, and does not pay the dividend tax until it is received by the shareholder, it may be possible to achieve deferral on the dividend taxation, thereby lowering the effective taxes paid by delaying payment of that dividend.
2. Individual Income Tax
The Act makes a number of important changes to provisions relating to the individual income tax. The Act changes the top marginal tax rate to 37% from 39.6%. It otherwise retains the current-seven bracket structure, but the bracket widths are increased and rates generally are lowered. The Act also repeals the so-called “Individual Mandate,” which required individuals to maintain health insurance or pay a penalty, starting January 1, 2019.
Under current law, individual taxpayers are permitted to make certain deductions regardless of whether those deductions arise in the course of a taxpayer’s trade or business, namely, State and local personal and real property taxes and income taxes.
Under the Act, for individuals, State and local property and sales taxes are allowed as a deduction only when paid in carrying on a trade or business. In other words, for property taxes, an individual may deduct a property tax paid only when it is imposed on a business asset, such as residential real property that is rented out. Further, under the Act, State income taxes are not allowed as a deduction.
An exception to the above rule was inserted by the Conference Committee. A taxpayer may claim an itemized deduction of up to $10,000 for the aggregate of (i) State and local property taxes not accrued in the course of a trade or business, and (ii) State and local income taxes paid in the taxable year.
As noted below, the amount of the standard deduction is greatly increased. The personal exemption, which is an amount that reduces taxpayer’s income and is based on the number of dependents and whether the taxpayer is married, is repealed.
3. Pass Through Entities
Under current law, the income of S corps and partnerships flows through the individual income tax return of the shareholders, members, and partners. Thus, income from a pass-through entity, under current law, is taxable up to 39.6%, which is the highest marginal tax rate.
The Act fundamentally changes the way pass-throughs are taxed. Under the Act, for taxable years beginning after December 31, 2017 and before January 1, 2026, an individual owner of a pass-through entity may deduct up to 20% qualified business income received from that entity. Qualified business income is the net amount qualified items of income gain, deduction and loss with respect to the qualified trade or business of the taxpayer which are “effectively connected” with a U.S. business. Qualified items of income, deduction or loss do not include long term capital gains, dividends, interest, certain gains from trade, and other items. The deduction for qualified business income is limited to the greater of (i) 50 percent of the W-2 wages paid, or (b) 25 percent of the W-2 wages paid plus 2.5 percent of the unadjusted basis of all qualified property (meaning tangible property subject to depreciation which is used in the particular qualified trade or business).
A qualified trade or business expressly does not include specified service businesses. This is any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. The exclusion from the definition of qualified business or specified trades or businesses phases in above a certain threshold amount, namely, $315,000 in the case of a joint return.
Many important tax planning opportunities arise out of this change to the taxation of pass-through entities. Businesses that fall into the definition of a specified trade or business may be able to take advantage of the deduction for pass-through entities by spinning out certain parts of their business that are passive in nature, such as rent from owning a building.
4. Estate, Gift, and Generation-Skipping Taxes
The Act also makes important changes to the estate, gift and generation skipping transfer taxes. These taxes generally impose a tax on certain lifetime transfers and transfers at death. Under current law, there is a “unified credit” against all three of the taxes. In 2017, the unified credit amount was $5.49 million per individual and nearly $11 million for married taxpayers. Amounts transferred above the unified credit were taxed at a rate of 40%.
Under the Act, the exclusion amount is raised from $5 million to $10 million, and will be indexed for inflation. Thus, over $20 million can be transferred without incurring estate gift or generation skipping tax for married taxpayers.
5. Tax-Exempt Organizations
The Act will affect tax-exempt organizations. Under current law, the percentage of adjusted gross income a taxpayer may deduct for charitable contributions to public charities and certain other organizations is 50%. The Act increases that amount to 60%.
Under current law, a charitable deduction will be allowed for payments to institutions of higher education in exchange for which the payer receives the right to purchase tickets or seating at an athletic event. The Act repeals that specific deduction.
Another important change to the current tax system that will affect tax-exempt organizations is the increase in the standard deduction. Under current law, an individual who does not elect to itemize deductions may reduce their adjusted gross income by the applicable standard deduction. In 2017, this amount was $6,350 for individuals and $12,700 for married individuals filing a joint return. Under the Act, the amount of the standard deduction is increased to $24,000 for married individuals filing a joint return and generally $12,000 for other individual taxpayers. That amount is indexed for inflation beginning after December 31, 2018. The charitable deduction is a deduction which can only be taken if a taxpayer does in fact choose to itemize and, therefore, the amount of taxpayers that will be able to take a charitable deduction is expected to fall.
6. International Taxation
The Act shifts the U.S. tax system away from the taxation of worldwide income of U.S. taxpayers to a territorial system of taxation. Under current law, a U.S. taxpayer pays income tax on income wherever located. Thus, many companies declined to repatriate those profits located abroad, but which have never been subject to U.S. income tax-an amount estimated at $2.5 trillion.
Under the Act, there is a 100-percent deduction for the foreign-source portion of dividends received from specific 10-percent owned foreign corporations by domestic corporations, that are U.S. shareholders of such foreign corporation. No foreign tax credit is allowed for any taxes respecting that dividend, and certain other provisions apply, including a holding period requirement.
Congress has also imposed a tax on accumulated foreign earnings via a deemed-repatriation tax, with differing rates dependent upon whether the earnings are held in the form of cash or otherwise. The Act also imposes a minimum tax on foreign earnings that exceed an amount equal to a standard rate of return on assets.
7. Business Taxes
In addition to the changes in the structure of business taxation addressed above, there are a number of changes to the taxation of businesses.
- Interest Expense: The deduction available for interest expense would be limited to 30% of “modified income,” with carryover to later years.
- Expensing: Under current law, there is a 50-percent bonus depreciation for short-lived capital investment, such as equipment. Under the Act, there will be full expensing of such short-lived capital investment for 5 years. This provision is phased out thereafter.
- Corporate Alternative Minimum Tax: The Corporate AMT is repealed.
- Net Operating Loss: A net operating loss (“NOL”) under current law may be carried back two years, and carried over 20 years to offset taxable income. Under the Act, the NOL deduction is limited to 80 percent of taxable income for losses arising in taxable years beginning after December 31, 20122. The provision also releases the two year carryback (which is effective after December 31, 2017).
The changes to the U.S. tax system contained in the Act are far-reaching and will affect many businesses and individuals. Once the Act is signed into law, regulatory developments will be important to monitor for planning purposes.
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