The Tax Cuts and Jobs Act: An Overview and Four 2018 Planning Suggestions

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Faegre Baker Daniels

For the first time in more than 30 years, the countdown to the New Year was also the countdown to major revisions to the tax code. The Tax Cuts and Jobs Act (Act) became law in late December 2017 and contains sweeping changes to corporate income tax and to individual income and transfer taxes.

The Highlights

The Act drastically increased the estate, gift and generation-skipping transfer (GST) tax exemption amounts while still allowing for a step-up in basis at a taxpayer’s death. Corporate income tax rates decreased by 14 percent, and a new 20 percent qualified business income deduction was established for owners of pass-through businesses. Individual income tax rates were generally reduced, and many deductions were reduced or eliminated. The Act also significantly changes the international tax laws that affect individuals with cross-border interests.

Some changes in the Act are permanent, but many sunset after December 31, 2025. They could be extended after that date, but any change in the current legislative majority could potentially result in an earlier return to prior law or other modifications.

Individuals should consult with their advisors to determine the optimal structure for their businesses and estate plans in light of the Act’s passage and future uncertainty. This article offers four initial 2018 planning suggestions, followed by a description of the key provisions of the Act. 

Four 2018 Planning Suggestions for Taxpayers 

1. Run the Numbers  

  • Estate planning. An individual taxpayer should request that his or her attorney, accountant or other advisor map out how the assets of the taxpayer’s estate will be allocated under the law in effect in 2017 versus 2018. Are the results consistent with the taxpayer’s wishes in both scenarios?  
  • Entity structure. Similarly, business owners should analyze the tax effects of their current business structure and the costs and benefits of a potential conversion.  

2. Consider Additional Gifting 

The doubling of the federal transfer tax exemption amounts is not permanent. These amounts reset to $5 million (indexed for inflation) on January 1, 2026. The increases could be made permanent, or the exemption amounts could possibly be reduced before 2026 if there is a change in the legislative majority.  

  • 2018 exemption is projected to be approximately $11.18 million. Individuals who had previously used their full federal gift tax exemption now have the opportunity to make additional gifts without the payment of gift tax. Any individual who is likely to have more than $6 million in his or her estate and married couples who expect to have more than $12 million may want to consider taking advantage of some or all of the doubled exemption amount while it is available.  
  • State taxes. The Act only doubles federal exemption amounts, and state tax must still be taken into account in any gifting proposal. A number of states impose an estate tax; however, most do not impose a gift tax. Therefore, making a lifetime gift to use additional federal exemption may avoid state transfer tax, whereas making the same gift at death (or in some states shortly before death) might not avoid state transfer tax. 
  • Basis of non-cash gifts. For non-cash gifts, consider the basis of a donor’s assets, and how the potential income tax savings after the death of the donor from the step-up in basis are likely to compare to the potential estate tax savings from using the temporary additional available exemption, and allowing future appreciation to occur under the recipient’s ownership.  

3. Consider Basis Planning for Highly Appreciated Assets

One of the objectives of estate planning has historically been to transfer assets out of a donor’s estate so that they are not subject to estate tax at the donor’s death. However, the substantial increase to the exemption amounts means that some donors may benefit from bringing assets into their estates.

  • Gifted assets retain basis. Many individuals have previously used their full exemption amounts to transfer assets during their lifetimes. The transferred assets retained their original cost basis and may have appreciated not only while they were held by the donor, but also continued to appreciate in the hands of the transferee.  
  • Use doubled exemption amount to achieve step-up in basis. In certain situations, it may be appropriate to transfer (through gift, exchange or otherwise) appreciated assets back to the original donor. If the donor dies with sufficient exemption remaining, presumably before January 1, 2026, then those assets will pass free of federal estate tax (due to the increase in the exemption amount) and will receive a step-up in basis. Of course, one will also want to consider any potential state transfer tax consequences before taking any such action. 

4. Add Flexibility

An estate plan with built-in flexibility can take advantage of current changes but also may be able to better weather future uncertainty. Most of the changes in the Act affecting individuals, including the doubling of the estate, gift and GST exemption amounts, only last through December 31, 2025 (barring further legislative action). There are various strategies that can be considered to allow the decision of how best to allocate the property that is includible in a decedent’s estate to be postponed to a date when the tax law in effect at the decedent’s death is confirmed.

Regardless of a taxpayer’s situation, the Act is likely to affect the taxpayer in some way. Careful consideration of planning options for 2018 and beyond has the potential to result in significant tax benefits for individuals and businesses.

What Are the Key Provisions of the Act?

Individual Income Taxes

Tax Rates

  • Rate schedules. There are still seven brackets for individual income taxes, but rates for many taxpayers will be lower. The top marginal rate is now 37 percent (down from 39.6 percent in 2017). The new individual income tax rate schedules are included at the end of this article.
  • Alternative Minimum Tax (AMT). The AMT exemption amount increased to $70,300 for individuals (from $54,300 in 2017) and to $109,400 for married couples (from $84,500 in 2017). The amount at which the AMT exemption phases out increased to $500,000 for individuals (from $120,700 in 2017) and to $1 million for married couples (from $160,900 in 2017).
  • Kiddie Tax. The net unearned income of children is now taxed at the ordinary income and capital gains rates applicable to trusts. (It formerly was taxed at the parents’ tax rates.)
  • Carried interests. Capital assets held in connection with a carried interest must now be held for three years (instead of one) to be taxed at the long-term capital gains rate.
  • Net Investment Income Tax. The 3.8 percent net investment income tax remains in place.

Deductions

  • Standard deduction increased. The standard deduction increased to $12,000 for individuals (from $6,350 in 2017) and to $24,000 for married couples (from $12,700 in 2017).
  • Personal exemptions eliminated. Personal exemptions are repealed. In 2017, each individual had a personal exemption of $4,050, meaning that a family of four taking the standard deduction went from being able to deduct $28,900 in 2017 ($16,200 + $12,000, assuming that the family fell under the phase out amount of $313,800) to only $24,000 in 2018 (in each case, assuming no other deductions).
  • Limit on deduction for state and local tax payments. The deduction for state and local taxes for taxpayers who itemize deductions will be subject to a $10,000 limit. This limit applies collectively to married taxpayers (meaning that the state and local tax deduction for each married individual is $5,000, regardless of whether they file jointly or separately). There was no limit in 2017.
  • Medical expense deduction changed. For the two-year period from January 1, 2017, through December 31, 2018, medical expenses exceeding 7.5 percent of adjusted gross income are deductible. On January 1, 2019, the floor returns to its former rate of 10 percent of adjusted gross income. 
  • Mortgage interest deduction decreased. Interest on acquisition indebtedness (mortgage debt incurred in acquiring, constructing or substantially improving a taxpayer’s residence) up to $750,000 is deductible, and interest on home equity indebtedness (non-acquisition indebtedness secured by a taxpayer’s residence) is not deductible. In 2017, interest could be deducted on acquisition indebtedness up to $1 million and the interest on $100,000 of home equity indebtedness was deductible.
  • Moving expense deduction eliminated. Moving expenses are no longer deductible. In 2017, the expenses of certain moves were deductible regardless of whether a taxpayer itemized deductions.
  • Personal casualty deduction largely eliminated. Personal casualty losses are no longer deductible except for those attributable to a disaster declared by the President. These losses were previously deductible to the extent they exceeded $100 plus 10 percent of adjusted gross income.
  • Value of athletic event seating rights must be subtracted from deduction for donation to college. Donors that receive rights to purchase tickets or seating for a college athletic event in exchange for a donation no longer may include the value of those rights in the deduction they take for the donation.
  • Deduction for expenses subject to 2 percent floor eliminated. Deductions for certain miscellaneous items, including job expenses, investment fees and expenses, tax preparation fees, and legal fees are eliminated. These items were previously deductible to the extent that they collectively exceeded 2 percent of a taxpayer’s adjusted gross income.
  • No income limit to itemized deductions. Taxpayers whose income exceeds $261,000 (for individuals) or $313,800 (for married couples filing jointly) no longer lose the benefit of up to 80 percent of their itemized deductions. 

Charitable Contributions. Cash contributions to public charities are deductible up to 60 percent of adjusted gross income, an increase from 50 percent in 2017.

Child Tax Credit. The child tax credit increased to $2,000 per child (from $1,000), with a larger portion being refundable (paid to families who do not earn enough to owe federal income taxes).

Alimony. For divorces after December 31, 2018, alimony payments are no longer deductible to the payor or treated as income to the recipient.  

529 Education Savings Plans. Tax free distributions are no longer limited to post-secondary education; amounts of up to $10,000 per year per student (regardless of the number of accounts held for such student) can now be made for K-12 private school tuition.  

Most changes to individual income taxes sunset after December 31, 2025.

Transfer Taxes and Estate Planning

Exemption Amount Doubles. The estate, gift and GST tax exemption amounts have doubled, rising from $5 million to $10 million, in each case indexed for inflation. This means that the amount an individual could transfer free of taxes was $5.49 million in 2017 and is projected to be $11.18 million in 2018. The annual gift tax exclusion did not double and is $15,000 in 2018 because of inflation adjustments.

The changes to the exemption amounts sunset after December 31, 2025.

Step-up in Basis Stays. When an asset of an individual is transferred at his or her death, its basis (its original cost for tax purposes) steps up to become its current market value as of the individual’s date of death. This is a significant tax benefit to recipients of highly appreciated assets, as they can then sell those assets without having to pay capital gains tax on the difference between the decedent’s original basis and the date of death value. This tax benefit remains in place under the Act. 

Portability Stays. Portability, a concept that allows a surviving spouse to use his or her predeceased spouse’s unused federal estate tax exemption amount, remains in place under the Act.

Corporate Tax Rates

Tax Rates for C Corporations Are Cut. The maximum corporate tax rate is cut from 35 percent to 21 percent. The corporate alternative minimum tax (AMT) is repealed.  

This change is permanent.

New 20 Percent Qualified Business Income Tax Deduction for Owners of Pass-Through Businesses. The Act establishes a qualified business income deduction for individuals, trusts and estates that own pass-through businesses as long as they meet certain qualifications. In an effort to prevent individuals from using pass-through entities to convert investment or earned income to deductible qualified business income, the Act imposes a number of limitations.

  • Qualified business income of an entity:
    • Is ordinary income less ordinary deductions
    • Is not investment income, including capital gains, dividends and interest 
    • Is not wages earned as an employee
    • Must be earned in a qualified trade or business
    • Must be “effectively connected” with the conduct of a U.S. trade or business
    • Is calculated for each separate business

The publicized amount of this deduction is 20 percent of qualified business income, but the 20 percent number is actually a cap.  

  • The qualified business income deduction is the lesser of:
    • 20 percent of the excess of taxable income over net capital gain and 
    • The lesser of 20 percent of qualified business income and the greater of:
      • 50 percent of the W-2 wages paid by the entity and 
      • 25 percent of the W-2 wages paid by the entity plus 2.5 percent of the unadjusted basis of qualified property.
        • Unadjusted basis is acquisition value.
        • Qualified property is tangible property subject to depreciation used in the production of qualified business income (not inventory) as long as the depreciable period (longer of 10 years or last day of the last full year of the regular depreciation period) has not ended before the last day of the year.
  • The W-2 limitation is disregarded if a taxpayer’s ordinary taxable income is less than $157,500 (for individuals) or $315,000 (for married individuals filing jointly). The W-2 limitation is phased in starting at $50,000 above the individual threshold ($207,500) and $100,000 above the married threshold ($415,000).
  • Each calculation is made with respect to a taxpayer’s allocable share of income, W-2 wages and unadjusted basis.
  • The deduction is not available to taxpayers in service businesses, unless the taxpayer falls under the $157,000/$207,500 (single) or $315,000/$415,000 (married) thresholds described above.   
  • The qualified business income deduction definition and formulas are likely to require interpretation by Treasury Regulations and/or the courts.
    • What is a “trade or business” or a “service business” for purposes of the qualified business income deduction?  
    • Under the plain language of the law, the same business with the same income may have different qualified business income deductions under different pass-through structures (S corp/LLC/partnership).

This is technically an individual income tax provision, but is described in this corporate tax section because it was included in the Act as a result of the tax cut for C corporations. Like the other individual income tax provisions, the qualified business income deduction for pass-through business owners sunsets on December 31, 2025.

Permanent Modification of Inflation Adjustment Index

Many tax benefits under the Internal Revenue Code are designed to increase with inflation. The Act requires that these tax parameters now be adjusted under the Chained Consumer Price Index for All Urban Consumers (the C-CPI-U) rather than the Consumer Price Index for All Urban Consumers (the CPI-U). The C-CPI-U takes into account that consumers will alter their consumption patterns more significantly in response to relative price changes, and will shift to cheaper goods in different item categories of consumer goods, rather than just cheaper goods within the same item category.  

This change will likely reduce all annual cost-of-living increases under the Internal Revenue Code, meaning that items such as social security payments are likely to increase more slowly.

The shift to the C-CPI-U is permanent.

Note: Although this article highlights some of the key provisions of the Act and describes several planning options, it does not cover all changes made by the over 500-page bill or all available planning strategies. Each taxpayer’s situation is different, and individuals should consult with their advisors to determine if there are additional provisions of the Act that could affect them or other planning techniques that could be beneficial.

2018 Federal Income Tax Rates

If taxable income is:

Then income tax equals:

Single Individuals

Not over $9,525

10% of the taxable income

Over $9,525 but not over $38,700

$952.50 plus 12% of the excess over $38,700

Over $38,700 but not over $82,500

$4,453.50 plus 22% of the excess over $38,700

Over $82,500 but not over $157,700

$14,089.50 plus 24% of the excess over $82,500

Over $157,500 but not over $200,000

$32,089.50 plus 32% of the excess over $157,500

Over $200,000 but not over $500,000

$45,689.50 plus 35% of the excess over $200,000

Over $500,000

$150,689.50 plus 37% of the excess over $500,000

Married Individuals Filing Joint Returns and Surviving Spouses

Not over $19,050

10% of the taxable income

Over $19,050 but not over $77,400

$1,905 plu 12% of the excess over $19,050

Over $77,400 but not over $165,000

$8,907 plus 22% of the excess over $77,400

Over $165,000 but not over $315,000

$28,179 plus 24% of the excess over $165,000

Over $315,000 but not over $400,000

$64,179 plus 32% of the excess over $315,000

Over $400,000 but not over $600,000

$91,379 plus 35% of the excess over $400,000

Over $600,000

$161,379 plus 37% of the excess over $600,000

Married Individuals Filing Separate Returns

Not over $9,525

10% of the taxable income

Over $9,525 but not over $38,700

$952.50 plus 12% of the excess over $38,700

Over $38,700 but not over $82,500

$4,453.50 plus 22% of the excess over $38,700

Over $82,500 but not over $157,700

$14,089.50 plus 24% of the excess over $82,500

Over $157,500 but not over $200,000

$32,089.50 plus 32% of the excess over $157,500

Over $200,000 but not over $300,000

$45,689.50 plus 35% of the excess over $200,000

Over $300,000

$80,689.50 plus 37% of the excess over $300,000

Estates and Trusts

Not over $2,550

10% of the taxable income

Over $2,550 but not over $9,150

$255 plus 24% of the excess over $2,550

Over $9,150 but not over $12,500

$1,839 plus 35% of the excess over $9,150

Over $12,500

$3,011.50 plus 37% of the excess over $12,500

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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