The Tax Cuts and Jobs Act (TCJA) certainly changed some key areas for individual taxpayers — expanding tax brackets, lowering rates (for most) and modifying the alternative minimum tax so far fewer taxpayers will be subject to it. The standard deduction also was enhanced, while personal exemptions and miscellaneous itemized deductions were eliminated, and state and local tax deductions were capped at $10,000.
All in all though, the changes didn’t go nearly as deep or wide as those offered to businesses. That is likely why we are now hearing about a middle-class tax cut, which promises more cuts to come for individuals.
For now we will focus on the certainty we have through 2025, after which point (absent new legislation) the individual tax provisions in the TCJA will sunset and previous law will again take hold. Below are some of the key provisions and opportunities individual taxpayers should be discussing with advisors prior to the end of 2018.
While there is a chance next year’s individual tax rates could be lower if Tax Reform 2.0 becomes a reality, we know for sure next year’s rates won’t be any higher. That means if you are receiving a gain and it won’t hurt your overall economic situation, it may make sense to defer gains and try for an even better rate next year. (See the Opportunity Zone section below for more on a new program to help defer gains.)
Section 199A – Qualified Business Income Deduction (QBID)
This is one of the most impactful and biggest changes for owners of pass-through entities. Essentially, for tax years 2018 through 2025, business owners (individuals, estates and trusts) of partnerships, S Corporations and sole proprietorships can take a maximum deduction of 20% of their qualified business income. The deduction is applied at the individual taxpayer level, not the entity level. However, for high-income taxpayers, wage limitations apply and specified service businesses are not eligible for the deduction if their taxable income is above a certain threshold.
To qualify without any limitations, pass-through entities may need to consider reducing their income so it falls under the $157,500 threshold ($315,000 married filing jointly). One way to accomplish this is to make contributions to retirement plans or health savings accounts.
>> Read more on the provision and recent guidance in “Proposed Regulations Clarify Tax Reform’s Business Income Deduction for Pass-Through Entities.”
State and Local Sales Tax Deduction
One of the biggest changes to individuals is the $10,000 limitation on state and local tax deductions, which includes income, real estate and personal property taxes. An additional anti-abuse provision eliminates the deduction in 2017 for prepayments of state and local income taxes for tax years in 2018 and beyond. States continue to try to come up with workarounds for their residents, but the IRS has already ruled against some of the ideas. You will need to closely monitor your state for ongoing developments and IRS action to see if any additional deduction options become available.
Individuals can now make cash contributions up to 60%, increased from 50%, of their adjusted gross income (AGI). For those who are able, a strategy may be to make large, single-year contributions to a donor advised fund — essentially “bunching” smaller annual donations into a larger one and then taking the standard deduction on subsequent years. It can help reduce the taxpayer’s income and the associated tax liability, while taking advantage of the larger deduction. The technique also can help mitigate the loss of other itemized deductions.
Miscellaneous 2% Deduction Elimination
We’ve seen a lot of movement from employers regarding the elimination of the 2% deduction, a deduction that allowed taxpayers to deduct items such as investment fees, unreimbursed employee business expenses, tax preparation fees, etc. Now that employees cannot deduct certain job expenses, some employers have opted to change their expense reimbursement plans to mitigate the loss on employees’ returns. Others have considered in the right circumstances to restructure roles so employees can become independent contractors so they can deduct more on their personal returns (and potentially qualify for the new Qualified Business Income Deduction as well). This area is a conversation some employers may want to have, or at least be ready for, with their employees.
This is an area to scrutinize if you have kiddie tax returns. The tax has been simplified, which is good, but now a child’s unearned income over $2,100 will be subject to trust tax rates. That means taxable income over $12,500 will be taxed at a 37% rate instead of the parents’ rate, and some parents won’t hit the 37% bracket until reaching $600,000 in taxable annual income. Consider whether it’s more beneficial to keep the income under a parent’s return, if possible.
College savings plans will now allow up to $10,000 per year for qualified elementary and high school expenses. There isn’t much in the way of new planning in this area, but it does provide new options for parents paying primary or secondary education tuition.
Net Investment Income (NII) Tax
Planning surrounding the 3.8% Medicare surtax on NII tax is important, particularly if you are involved in any sort of transaction, but remains unchanged from last year. Continue to consider the following:
Reduce NII by selling property with losses, postponing capital gains, using an installment sale to spread a large gain over a number of years, deferring gain with a 1031 exchange or donating appreciated securities
Reduce modified adjusted gross income by maximizing retirement plan contributions or changing the type of assets in which you are invested
Qualified Opportunity Zones
The new Opportunity Zone program is a potentially exciting opportunity for deferring capital gains. The program is designed to incentivize long-term investment in low income and economically distressed communities by deferring capital gains tax when taxpayers invest those gains into Qualified Opportunity Funds (QO Funds). A taxpayer with realized capital gain from an unrelated party has 180 days to invest in a QO Fund and can defer that gain until whichever event occurs first: 1) the sale of the QO Fund interest, 2) the QO Fund ceases to qualify or 3) December 31, 2026. The original deferred gain is reduced based on how long the QO Zone Fund is held, and post-acquisition appreciation on the QO Fund investment is permanently excluded from tax if the investment is held for 10 years or longer. As always, it is important to evaluate any investment carefully and discuss with your investment advisor.
>> Learn more about the program in “Tax Reform Watch: Qualified Opportunity Zones.”
Estate Tax Planning
The TCJA doubled the estate and gift-tax exemption to an inflation-adjusted $11.2 million for individuals and $22.4 million for married couples through 2025. So while many taxpayers are no longer subject to the federal estate tax, the next eight years are a prime opportunity to consider increasing gifts made during your lifetime to minimize tax upon death. Another planning option that’s become even more beneficial with the new increased exemption is income tax basis planning. Even though many taxpayers may not pay estate tax, if they can get a step up in their basis they could minimize or eliminate income tax obligations for heirs when the estate is sold.
Basic estate planning blocking and tackling are still pretty important as well, such as transferring out assets under annual exclusions ($15,000 per donee) and ensuring older estate planning documents are up to date — especially if they reference the prior exclusion number. Non-tax-related estate planning also remains critical.
The message this year is don’t assume anything! The loss of key deductions and other changes doesn’t necessarily mean your tax situation will be worse off than before. You will need to carefully consider all of your deductions, changes to the law and new opportunities to really know where you stand.
Please contact a member of your service team for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.