Nuggets from the Tax Cuts and Jobs Act (TCJA)

My November article speculated on what was coming in the new tax bill and how it would affect us. Of course the final version tilted the whole structure off its foundation rendering that article into garbage right now. And then the IRS kept tinkering with what expenses are and are not allowed in 2017 – almost down to New Year’s Eve, so December was a chaotic month for tax planning, to say the least.

I have watched a 4-hour CE course on the new law three times! I promised to post any new thoughts on the WCI Forum then realized that the post would be so long that nobody would want to read it! The compromise is this blog post which, hopefully, a few people will get through.

What I learned is that this law is far more complex than I realized. The areas discussed were rife with “maybe”, “when the regulations come out”, and “I think…” Apparently, the bill-writers included precious few examples of transactions under the new law, leaving most of us scratching our heads. I decided to write this for those who have a reasonable familiarity with TCJA (see the 570-page Joint Explanatory Statement of the Committee of Conference for reference). Below are some of the nuggets I gleaned from the triple-webinar along with time spent Googling various experts’ points of view. This post by Michael Kitces is another great resource, which he has, so far, kept updated.

Kiddie Tax

Before TCJA, unearned income over $2,100 was taxed at the parents’ top marginal rate. Now, children are taxed at trust tax rates, which is a staggering 37% at income over $12,500. The sweet spot, where most physician families will fall, is income between $2,550 and $9,150 with a tax rate of 24%. Of course, if you are saving in a 529, your effective tax rate is zero!

Roth recharacterizations

Recharacterizations of Roth IRA conversions will no longer be allowed after 12/31/17. This will put more uncertainty into the decision to convert to a Roth IRA.

  • Now that I’ve thought it over, I like the fact that this provision takes the element of market timing out of conversions. Once you convert, there is no looking back.
  • There is some confusion about whether conversions in 2017 can still be recharacterized in 2018 and until what date. Michael Kitces says you should be able to recharacterize but then retreats into uncertainty.
  • Those who will be affected most often are people doing backdoor Roths who are accidentally snared by the pro-rata rule with a pre-tax IRA.

Qualified Business Income (QBI) and Section 199A (or, the “Pass-Through Entity” rule)

Planning opportunities abound with the new rule allowing a 20% deduction on QBI. After repeating the webinar twice more, I still left with more questions than answers, but I’ve included some of the most helpful comments below:

  • For certain professionals with taxable income above $157,500 (single)/$315,000 (MFJ), your QBI deduction will be phased down to zero over the next $50k (single)/$100k (MFJ) of taxable income. NOTE that we are used to measuring tax attributes by AGI but the above limitation is based on taxable income not adjusted gross income (AGI).
    • Affected professionals include doctors, attorneys, accountants, actuaries and consultants, performing artists who perform on stage or in a studio, paid athletes, professionals in the financial services or brokerage industry and “any trade or business where the principal asset is the reputation or skill” of the owner. Not included in the traditional service profession are engineers and architects. But an engineer operating a business based on his or her reputation or skill is still a specified service trade.
  • If you are not in these qualified professions, your section 199A deduction is limited to the GREATER of either:
    – 50% of your allocable share of W-2 wages paid by the business, or
    – 25% of the taxpayer’s allocable share of W-2 wages paid by the business plus 2.5% of the taxpayer’s allocable share of the unadjusted basis immediately after acquisition of all qualified property
  • You will be able to manipulate your QBI with itemized deductions (think Donor-Advised Funds).
  • The QBI deduction is calculated at the entity level, but passes through to the taxpayer level on K1s.
    • This means that lower-income business owners may benefit even though upper-income owners are phased out.
  • Each business entity owned by the taxpayer(s) will be calculated separately and then aggregated. This is a very important point because some profits will be excluded from the whole QBI calculation due to wage limitations.
  • While the IRS requires “reasonable” wages in S-corps, there is no comparable rule for partnerships.
    • As an S-corp owner/employee, your wages will reduce your QBI tax deduction. This is another motivation for s-corp owners to pay themselves a low salary…therefore…
    • Expect the IRS to step up efforts to audit S-corps on reasonable wages.
    • Likewise, guaranteed payments to partners reduce the QBI available for the pass-through deduction. Partners will be incentivized to move from a guaranteed payment structure to “distributive shares”.
    • If a partnership has no wage structure (reducing your QBI to zero), it could be feasible to elect to be taxed as a corporation under the “check the box” rules and then elect “S” corp status.
      • Real estate partnerships will not need wages for QBI because they get to include 2.5% of the acquisition cost of depreciable assets in the limitation calculation as long as the assets have not been held longer than the shorter of 10 years or the depreciable life of the property.
    • Rental real estate income (passive income) counts as a qualified business for purposes of the QBI deduction calculation.
    • Any trade or business that relies on the “reputation or skill of one or more employees” is a disqualified business for purposes of the QBI deduction. This includes most traditional white collar professions such as medicine, law, and accounting.
      • If your business can be separated between retail and service, it could be beneficial to set up two entities. An example would be an ophthalmologist who also sells eyeglass frames.
      • This rule does not apply if the taxable income of the owner falls under $157,500 per spouse.
    • It appears that the 20% QBI deduction also applies for calculating AMT.
    • The QBI deduction does not appear to reduce SE (Self Employment) taxable income.

Apparently I was not the only person still confused by this provision! I look forward to learning more.

Mortgage interest limitation

  • If you do not refinance a mortgage dated before 12/15/17, you can continue deducting mortgage interest on up to $1M of debt, rather than the new $750k limitation.
  • You can continue to deduct mortgage interest on two homes, but the deductible limitation has been lowered from $1M to $750k unless the properties have pre-12/15/17 mortgages.
  • Home equity interest is deductible only until 1/1/18 unless the proceeds of the home equity loan were used to buy, build, or substantially improve the home. If that is the case, the debt is treated as “acquisition indebtedness”, not a home equity loan. We’re still not sure exactly how the limits work:
    • Either as part of the $750k overall limitation (not grandfathered), or
    • Limited to interest on $100k of home equity loan under pre-TCJA law (grandfathered).
  • The $750k is not a cliff, it’s a limitation. That means if you have a mortgage of over $750k, you still get to deduct interest on the $750k.
  • No idea if you’ll get to use up the vacation home interest deduction first if it has the higher rate or if you’re required to start with your primary residence’s mortgage.

Loss of deductions limited to “in excess of 2% of AGI”

You will no longer be able to deduct employee home office, mileage, and travel expenses, CPA fees, investment advisory fees, and other expenses related to the production of income.

  • Investment advisory fees were sometimes deductible even for high income professionals who paid under an AUM system for 7- and 8-figure investment portfolios. You’ll now need to:
    • Pay management fees on your TIRA from the account itself. Because you are taking your fee from a pre-tax account, this preserves the deductibility of your fees on TIRAs.
    • Avoid paying fees for Roth IRAs from the Roth itself as there is no benefit – you’ll just deplete the Roth.
    • Note that financial planning fees are not deductible in any way unless they are for business planning.
  • This would be a great time to talk to your employer about putting in an accountable plan. If you are paying taxes because of significant unused employee business expenses, consider negotiating a salary cut in exchange for reimbursed business expenses.
  • This also means that losses on a variable annuity are no longer deductible, negating the benefit of the popular §1035 exchange of a whole life policy into an annuity to deduct a loss on cash-out.
  • Not sure yet, but the loss of individual investment fee and CPA deductions could also apply to trust and estate income tax returns.

Family Medical Leave Act (FMLA) tax credit

Employers get a tax credit of up to 25% of wages paid to employees who take up to 12 weeks’ family leave under FMLA. Hopefully, more employers will allow paid maternity and family leave benefits as a result.

Loss of exemptions

It’s my understanding that the IRS wage withholding rules for 2018 remain the same as for 2017, even though we no longer are allowed personal exemptions. For a family with several children, you could be under-withholding by accident. You might want to run through your withholding calculation with your CPA after you’ve received your first paycheck in 2018 or get your calculator out to see if you’re withholding enough.

Alimony

For divorces taking place after 1/1/19, alimony will not be deductible by the payor and will not be taxed to the recipient.

  • This will lead to a change in divorce settlements and allocating payments between child support and alimony. Now that there is no tax benefit for either, children will “need” relatively more to maintain their lifestyles – until age 18, that is.
  • Divorces before 1/1/19 will be treated as before unless you take your ex back to court.

AMT

The Alternative Minimum Tax (AMT) wasn’t totally abolished, but a lot of the sting was taken out for high income families. Most of the deductions that had to be added back to calculate AMT are gone and the exemption has been increased by 27%, meaning it is far less likely physicians will owe AMT beginning in 2018.

Estate tax exemptions doubled

The need to plan for estate taxation is greatly reduced, at least until 2025.

529 plans

  • Unused 529 money can be rolled over to an ABLE account. This will allow a limited number of people who have overfunded 529s to help out a disabled friend or family member with funds that will not be means- or resource- tested.
  • Up to $10k/yr. of 529 dollars can now be used for K-12 schools.
    • Annual contributions to Coverdells cap at $2k/yr. but grow tax-free, same as with 529s. As one of our clients astutely pointed out, many private schools cost more than $10k/yr. so Coverdell ESA accounts will still have value.
    • The ability to contribute to Coverdells phases out at $110k (single)/$220k (MFJ). For high income households, the contribution must come from someone with income below these thresholds – such as the child. To do this, you will need to open an UGMA/UTMA, gift the child $2k/yr. and let the child contribute to his/her own account.
    • For simplification purposes when you have multiple children, open only one UGMA/UTMA and let one child make the contributions on behalf of all siblings.

Loss of exemptions

It will be more feasible to let your college age kids who are earning money file and claim their own standard deduction now. Win-win if you own a business and can put them on the payroll.

In closing

  • Don’t expect clarification on many provisions before the end of 2018.
    • This will play havoc with tax planning during 2018.
  • Applying reasonable standards of judgment until the law is ironed out may yield some benefits that, while not intended by Congress, are not yet clarified.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s