Significant Tax Changes Are Expected
As we are in the last five months of the year, it is time to begin updating the books, making projections and identifying possible tax strategies during these closing months of 2017.
Year-end income tax planning is also often a good season for looking at the bigger picture – 3-5 year projections, successor planning for the business, estate planning essentials, etc.
We should soon know whether to expect possible tax legislation by year end. It is quite possible we will have a new tax bill. There is the prospect of significant changes.
Planning When Details Are Uncertain
President Trump wants significant rate reductions while doing away with many deductions and possibly limiting others. There’s a dearth of new tax incentives, which is something of a change in the pattern of modern times. The general context is reducing the number of specialized, targeted tax incentives while also eliminating some big revenue raisers for the government.
Despite all the talk of tax reductions aimed at stimulating the economy, there are some projections that a significant number of taxpayers, particularly those earning around $150,000 to $300,000, may actually owe more tax under the new bill because of fewer deductions. ((“The Winners and Losers of a Tax Overhaul,” Tax Report, Laura Williams, Wall Street Journal, July 29-30, 2017, p. B4.))
In general, renters may fare better than home owners under proposed changes that may eliminate the property tax deduction on your home while preserving the home mortgage interest deduction. Taxpayers in states with high income tax rates may fare poorly in comparison to no-tax or low-tax states because the Trump proposals also eliminate the state income tax deduction. This is a prospect that, if it materializes, may dictate some detailed analysis of what state tax payments to make late in 2017 assuming such payments would still be deductible.
Some discussions suggest investment expenses may no longer be available as itemized deductions. If this materializes, this could eliminate investment interest deductions as well as, e.g., property tax deductions for investment realty, which may trigger reviews ranging from disposition to converting investment realty to rental realty. There are issues here of fundamental fairness; i.e., sometimes not being able to deduct directly related expenses.
An argument focusing on fundamental fairness could also be made with respect to the prospect of not being able to deduct employee expenses – the teacher’s school supplies or the employee-broker’s Wall Street Journal subscription. Under current law, employee business expenses have to rise above 2% of adjusted gross income before they are deductible. Some discussions suggest employee business expenses may be eliminated altogether.
An argument that these changes are fair might emphasize that the context is one of an enhanced standard deduction, and it is a substitute for itemized deductions.
Nobody knows what will be enacted or even whether we’ll have a dramatic tax bill this year, although prospects seem enhanced. The national attention is returning to this all important topic.
In 2017, there is some likelihood of relief this year in that the express purpose of the legislation is primarily to stimulate the economy, but effective dates are uncertain.
Even further down the road is the possibility of conforming state tax changes.
The most important issue is what steps to take by year end. This is our emphasis – although necessarily very tentative at this stage.
Changes Affecting Taxpayers Generally
Federal rates may be significantly reduced at least for many taxpayers. If lower tax rates become effective in 2018, we may be thinking in terms of income deferrals and deduction accelerations – typical year-end planning. Just because of the time-value of money, income deferral and accelerating deductions are generally good ideas.
This suggests, for example, that cash-basis taxpayers may be paying business expenses by year end, and sending out bills to clients a little later. Note that there is a “constructive receipt” concept in the tax rules that can limit one’s ability to shift income to future years. For example, if you receive a client fee in late 2017, it is taxable in 2017 even if you hold off taking the check to the bank until 2018.
Taxpayers generally may be looking closely at maximizing IRA and similar contribution deductions in the 2017 return. It would be the rare taxpayer who would incur the taxes to convert to a Roth IRA in this proposed legislation environment.
Everything turns on the taxpayer’s particular circumstances and detailed calculations, projections. The opposite of our generalities may be true in your particular circumstances.
In general, one of the major planning issues with large capital gains in 2017 is the 3.8% tax on net investment income enacted as part of Obamacare.
Planning with respect to this special tax is less of an issue with dividends and interest, which are reasonably predictable. The Section 1411 tax may be an unanticipated factor with large investment gains. There is some talk of repeal of this tax. It continues to be an issue in planning for large gains until we know there is such a repeal and understand the effective date of any repeal.
Note that this tax does not apply to the seller of shares in an S corporation or interests in partnerships and LLCs in which the seller is an active employee, partner, manager, member or officer. So there is no need to defer the sale of these businesses to avoid the net investment income tax
The general tax rule is that if you give up this for that, the fair market value of the new asset relative to your basis in the old asset translates into taxable income. We’re used to thinking of tax-free exchanges of, usually, real estate. However, there are discussions of repeal of the Section 1031 like-kind exchange rule. While it seems unlikely the Congress would go so far as to repeal the like-kind exchange concept, the Congress is focused on what needs to be sacrificed for rate reductions, and reports are that this is up for consideration.
The prospect that the like-kind exchange concept may go away or become less accessible suggests looking in the near-term at such transactions.
In general, like-kind exchanges have the advantage of avoiding (or reducing) the current recognition of income at a cost of reduced basis in the like-kind property received.
One of the inherent disadvantages of the like-kind exchange regimen is that it limits the ability to choose your investments. For example, you may be willing to exchange real estate investments tax-free but would prefer to shift more assets away from real estate. As we all know but sometimes need to remind ourselves, taxes are only one factor in the analysis.
The Trump proposals increase the standard deduction without eliminating the concept of itemizing. However, they would basically preserve only the charitable and home mortgage interest deductions. We might see more limits on the level of charitable contribution deductions.
In general, many taxpayers will shift from itemizing to using the standard deduction. It is contemplated that there will be increases in the standard deduction, such that many taxpayers will no longer reduce their tax as a result of charitable donations.
For those who can reduce their taxable income as a result of their itemized charitable gifts, their tax savings may be reduced by reductions in tax rates.
Depending on the state of the tax changes at year end, it is possible that there will be an incentive for charitable donations by year end.
If the estate tax is repealed, this would also trigger a review of testamentary charitable dispositions that presumed major savings in estate tax. It is not uncommon in mega-estates to have huge charitable donations because such transfers, if going to family, would trigger major levels of estate tax. The estate tax charitable deduction, unlike the income tax deduction, is unlimited.
In general, most charitable disposition decisions can be postponed until relatively late in the year, even if there are property dispositions to charity, not just year-end checks. But there are exceptions; e.g., if the taxpayer may be considering a private foundation or charitable remainder trust, it is best to begin such deliberations well in advance of year end.
Charitable donations made by check must be in the hands of the post office by December 31st to be deductible in 2017. Year-end donations of publicly traded stock require earlier action.
There are income tax rules that limit charitable donations to a percentage of income.
Planning for the Business Taxpayer
Helping the business taxpayer is frequently said to be the main impetus for proposed tax changes.
Controlling Business Income by Planning Capital Expenditures
President Trump has expressed an interest in expanding the Section 179 provision that generally allows certain taxpayers to expense their capital expenditures rather than depreciate them over multiple periods.
For 2017, if the taxpayer places in service qualifying Section 179 property that exceeds $2,030,000, the dollar limit of $510,000 is scaled back. This benefit is eliminated at the level of $2,540,000.
In general, tangible personal property and off the shelf computer software qualify. For example, a large manufacturing press would qualify. A building would not qualify for this special expensing provision because it is not personal property.
There is provision for carryover but this provision cannot be used to create a net operating loss to carryback to pre-2017 years in which the tax rates may be higher. However, if the capital expenditures are in place by year-end, one might use the expense election to offset higher tax rates of 2017.
If the taxpayer contemplates possible use of this provision, now is the time to plan capital additions.
There is also a “bonus depreciation” provision which generally allows the taxpayer to write off 50% of new tangible property if the recovery period is 20 years or less (so it would not apply to building structures per se).
“Qualified improvement property” is eligible for bonus depreciation. “Generally, this is any improvement to an interior part of a building that is nonresidential real property. The improvement is placed in service after the date the building is first placed in service and is section 1250 property.” ((IRS Pub. 946, “How to Depreciate Property,” 2016, p. 26.)) This doesn’t apply to an enlargement of a building, an elevator or escalator, or the internal structural framework of the building.
Basis is reduced first by the Section 179 expensing election, then this 50% bonus depreciation provision, then the normal depreciation rules apply.
There is another relief provision that generally allows expensing building improvements that would otherwise be added to the asset account. This rule generally sanctions writing off building improvements to the extent of the lesser of 2% of the unadjusted basis of the property or $10,000. ((Regs. 1.263(a)-3(h).))
In general, there is talk of eliminating many special incentives. In the real estate field, there is some concern that such “simplification” may affect low-income housing investments or the period of writing off leasehold improvements.
Net Operating Losses
The 2017 proposals by Republican Representative Ryan include repeal of the ability to carryback net operating losses. The prospect of having no net operating loss carryback after 2017 suggests it may be advantageous to have a loss in 2017, particularly if your tax rates in the carryback years were high. The basic idea is losses might benefit old years more than future years. This is very much a computational exercise particularly since not all deductions translate into additional net operating loss. Another issue is whether, if repeal of the net operating loss is part of new legislation, this significant change will only be effective for years after 2017. What will be the effective date if such a proposal is included in the tax reform bill as a revenue raiser to pay for rate reductions? We should know by year end.
In general, carrying losses from one year to another is an income tax concept that doesn’t apply for purposes of the self-employment tax, which is the payroll tax for the self-employed. Accordingly, one of the factors to evaluate in accelerating deductions to the point of creating losses is whether such steps waste deductions that would otherwise reduce the self-employment tax. For example, Form 1040, Schedule C business income of zero in each of two years translates into no self-employment tax in either year, whereas a $100,000 loss in one year and $100,000 of income in another year triggers self-employment tax on $100,000 of the income.
Planning for the Closely Held C Corporation
The planning here is complicated by the need generally to plan both “outside” and “inside” the entity.
With a C corporation particularly, there are issues of deferrals and which year might be best for particular income or deductions, as well as sheltering the entity’s income with salaries, fees and bonuses,
The current legislative environment is one of rate cut backs combined with eliminating some tax benefits, but we don’t anticipate significant reductions in the tax benefits associated with pension/profit-sharing plans. So owners of closely-held businesses may still want to maximize contribution deductions. The main exception to that statement would be that pension/profit-sharing contributions would save less tax if there are reduced tax rates.
In general, we anticipate lower corporate rates, but it is still early to even generalize in such areas as whether one would want to leave a particular level of income in the corporation.
Planning for the Flow-Through Entity
The discussions suggest that flow-through business income from an S corporation or partnership will be taxed at a lower rate than in the past. Keep in mind that it is uncertain whether these concepts will be enacted and, if so, their effective date.
This may suggest the “normal” tax strategy of deferring business income to 2018 and accelerating business expenses in 2017.
Some suggest that with President Trump’s proposal for rate relief for owners of flow-through entities there may be a new tax on distributions from such entities; i.e., they may be taxed like C corporation distributions. There’s some discussion of rate relief on flow through income but only if the income is retained in the business. If new legislation takes this approach, it suggests that at some point after the effective date there may be an advantage to deferring distributions out of the business to the partners or S corporation shareholders. Owners of flow-through entities may also want to consider distributions of liquid assets in 2017 to the extent the assets aren’t needed as working capital.
There is some discussion that the new law may bring into play some characterization of flow-through income as “reasonable compensation,” rather than business income eligible for lower tax rates. Valuable employees may press for ownership interests in the flow-through entity if flow-through income is taxed less than wages.
If there are significant changes in the income tax rules governing flow-through entities, will Congress also consider revisions in the self-employment/payroll tax for the owners?
We just don’t know whether there will be introduced some major new concepts in the taxation of flow-through entities, but the general context suggests a desire for some rate relief with respect to flow-through business income.
If the general context remains one of rate reduction, we will likely be looking at year end planning with an eye to deferring income and accelerating deductions.
Gift and Estate Tax Planning
The basics of estate planning are, of course, still with us. One needs to have in place living trusts, wills, powers of attorney, medical directives, etc.
Generally it is only the larger estates (assets exceed $10,980,000 for couples, and $5,490,000 for single taxpayers) that actually incur estate tax under current law. These 2017 threshold amounts are reduced when there are lifetime gifts exceeding the annual gift tax exclusion. But if your assets are exposed to the estate tax, do you forego some of the traditional valuation reduction strategies because there is the prospect of estate tax repeal? Not necessarily. There may be issues of premature, unexpected demise, and the estate tax is with us until such time as it is actually repealed – if it will be repealed. So estate tax planning, with myriad strategies and complexities, is very much with us.
With all the discussion of repeal of the estate tax, can we also assume the gift tax will be repealed? Not necessarily. Discussions advocating repeal of the estate tax are at times surprisingly silent about also repealing the gift tax and generation-skipping tax.
There is also the issue of the effect of gift tax repeal on income tax planning. Some may argue that repeal of the gift tax might make it too easy to move assets among family members to take advantage of losses or lower tax rates.
Particularly if you have significant wealth, don’t plan on tossing that box of old tax records. In general, while there are exceptions, current law provides that the basis of inherited assets is fair market value at death, a concept that avoids having to prove costs incurred long ago, not to mention possible depreciation details that affect basis. The Trump proposals include the concept that there won’t be step-up in the basis of assets at death as to assets over $10 million. It is also possible that assets over that amount will be taxed at death as if the decedent sold them.
If new legislation does include some provision for carryover of the decedent’s basis to heirs for income tax purposes, this will introduce a new element of planning complexity in terms of the basis of assets. There is also the practical matter of finding the decedent’s records of cost (or other basis).
There is significant likelihood of major changes in the near term and one can glean some general perspective on how to prepare. Our message is to prepare but also wait to see what details emerge with respect to the proposed new tax legislation. Almost certainly there will be significant year-end planning considerations as the end of 2017 approaches. This will be true whether or not there is a new tax bill by December 31st.
The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230, as the content of this document is issued for general informational purposes only, is intended to enhance the reader’s knowledge on the matters addressed therein, and is not intended to be applied to any specific reader’s particular set of facts. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. Applicability of the information to specific situations should be determined through consultation with your tax adviser.