Changes in the tax law are still possible as we approach the end of 2018. However, the environment is nothing like that of December, 2017 with the major changes of the Tax Cuts and Jobs Act.
With all its benefits, there are many cut-backs in deductions in the 2017 Act. Taxpayers are just beginning to realize that there were many tax-increasing aspects to the 2017 Act that may apply to them. Generally, the rate cuts were combined with many reduced deductions and a few increased deductions.
Your 2018 year-end planning may well be more complicated than ever due to the admixture of positive and negative provisions of the new law.
We remind the reader that year-end tax planning is often best combined with big picture planning – 3-5 year projections, thinking about who may next own and run your business, estate planning, etc.
The 2018 individual rates come in seven brackets – lower-10%, 12%; mid-range – 22%, 24%; and higher brackets of 32%, 35% and 37%.
The top bracket of 37% begins at $600,000 with a joint return, $500,000 with a single return.
For taxpayers filing jointly, the lower rates end and the mid-range rates begin at $77,400 of taxable income. For joint filers, the mid-range rates end and the higher rates begin at $315,000.
For singles, the lower rates end and the mid-range rates begin at $38,700 of taxable income. Their mid-range rates end and their higher rates begin at $157,500.
With all the changes, the return still basically divides into reporting income and certain deductions allowable whether or not you itemize – this figure is “adjusted gross income.” In 2018, we no longer have personal exemptions for individuals but adjusted gross income is still reduced by itemized deductions or the standard deduction in arriving at taxable income.
Accessing the new, very important 20% of business income deduction doesn’t turn on whether or not one itemizes although itemized deductions will often impact the calculations.
Compared to 2017, the standard deduction is somewhat higher and itemized deductions are generally fewer, so more taxpayers will be using the standard deduction.
Standard deductions for 2018 are as follows: joint filers $24,000, heads of household $18,000, and singles $12,000. To these amounts, add $1,600 if 65 or over or $3,200 if this age and blind. On a joint return, the added figure is $1,300 for each spouse age 65 or older or blind; e.g., four times $1,300 if both spouses are age 65 or older and blind.
Itemized deductions are in some cases reduced. Notably state income taxes and property taxes are limited to a total of $10,000. If you plan to itemize in 2018, consider paying your state income tax estimated payment due January 15, 2019, by December 31, 2018, if this it yields an incremental deduction. These taxes are not deductible in computing the alternative minimum tax. We can generally help you weigh these pay-by year-end decisions. They can get complicated.
Also note that most itemized deductions that were not deductible until they exceeded 2% of adjusted gross income, including most employee expenses, are not available in 2018. Employees are not currently entitled to deduct their home office expense (including any allocable property taxes) even if they continue to use the space exclusively for job-related work. Self-employed persons may qualify to deduct an allocable portion of mortgage interest, property tax, depreciation, utilities, and insurance relating to their home office, assuming rather stringent tax rules are satisfied.
Itemizing in alternate years is a strategy that can often help.
The general rule for home mortgage interest is that it is an itemized deduction to the extent attributable to $750,000 for mortgages incurred by December 15, 2017, or later. There is a $1 million grandfathered limitation for earlier qualified home loans.
Unreimbursed medical expenses are deductible in 2018 to the extent they exceed 7.5% of adjusted gross income. So particularly if 2018 has lower adjusted gross income, it may be a good year to incur and pay discretionary medical deductions. If one spouse has relatively low income plus medical expenses, filing separate returns to maximize medical deductions may be worth considering, but one of the issues with such a plan is that the alternative minimum tax may become a problem.
If you’re under a high deductible health care plan, you may qualify to make deductible contributions to a health savings account (HSA) or your employer may make contributions, within limits, without such contributions being taxable. ((See IRS Publication 969.)) If you make such contributions, even though medical in nature, this particular deduction is available, within limits, even though you use the standard deduction rather than itemize. .
Due to the complexities, it is generally good to retain records of itemized deductions and other tax data after filing even if you used the standard deduction.
Investment interest expense incurred to purchase taxable investments, to the extent not allocable to tax-exempt muni bonds and to the extent of investment income, is still deductible as an itemized deduction. For this purpose, investment income includes such items as taxable bond interest and ordinary dividends. Qualified dividends and long-term capital gains on investments subject to the reduced capital gains rate don’t qualify as investment income for this purpose unless you elect to forego the favorable tax treatment otherwise accorded the income. Investment interest expense related to a passive activity would be subject to the rules limiting the deduction of passive losses.
With large long-term capital gains, another important nuance to the taxation of investment income is that such income may incur a 3.8% tax under Section 1411. Planning with respect to this special tax is less of an issue with dividends and interest, which are reasonably predictable. The Section 1411 tax needs to be considered in planning for large investment gains, including possibly installment reporting, and looking at whether to make a significant retirement plan contribution..
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.
If you’re in a fairly high bracket, your selling long-term capital gain stock may well trigger gain at the 20% long-term gain rate (the maximum such rate) while also triggering the 3.8% tax. Both taxes might be avoided, depending on the math, if you gave the appreciated securities to your child just starting his or her first job and the young adult realized the gain while his or her salary and other income are relatively low.
Also, older taxpayers will want to weigh heavily the possibility of retaining highly appreciated assets for life. The basis of inherited assets is still generally fair market value at death, so the heirs can usually sell the same assets with little or no gains tax. Both halves of appreciated community property generally step-up upon the death of the predeceasing spouse.
The passive loss rules are generally designed to limit business loss deductions when the partner/Subchapter S shareholder is less active. Consideration of these rules is still with us as part of year-end and year-round planning. Part of the planning with these rules focuses on the level of involvement toward the goal of making loss deductions non-passive or perhaps even making positive-income activities passive. Unless you’re a real estate professional, real estate activities are generally considered passive.
Changes Affecting Taxpayers Generally
The rates were reduced in 2018 compared to 2017 but federal rates in 2019 are uncertain as we plan in the latter part of 2018. There is still talk of further reductions in the rates. However, after the November 2018 elections, there is also talk of increases in tax rates.
In planning generally, we are still focused on 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 2018, it is taxable in 2018 even if you hold off taking the deposit to the bank until 2019.
Taxpayers generally may be looking closely at maximizing IRA and similar contribution deductions in the 2018 return.
The alternative minimum tax was repealed for corporations but not individuals. It applies less often due to an enhanced exemption with the 2017 Tax Act. The standard deduction isn’t available in computing the AMT. State and local income taxes and property taxes are add-backs in figuring the AMT. The AMT exemption also begins to phase out at high income levels, which can be caused by large capital gains. When the AMT is a possible factor, the tax planning can get complicated.
Everything turns on the taxpayer’s particular circumstances and detailed calculations, projections. The opposite of our generalities may be true in your particular circumstances.
The general tax rule is that if you receive one asset in exchange for another asset, 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, and tax-free exchanges of investment real estate are still possible. However, generally, tax-free exchanges are much more restricted under the 2017 Tax Act.
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.
Non-business casualty and theft losses are now generally restricted to those in a federally declared disaster area. Such losses are reduced by $100 and must exceed 10% of adjusted gross income. With such losses, it is also possible to assert the deduction in the year that precedes the actual disaster.
Itemized deductions are more restricted but still with us.
There are income tax rules that limit charitable donations to a percentage of income. In general, many taxpayers will shift from itemizing to using the higher standard deduction. In a year in which one uses the standard deduction, taxpayers don’t reduce their tax as a result of charitable donations.
The 2018 limit on charitable donations in one year is actually higher, 60% of adjusted gross income for cash contributions to public charities and certain private foundations. This compares to the traditional rule of 50% of adjusted gross income.
Capital gains shifting and avoidance are still important planning considerations. Instead of significant cash donations to your favorite charity, consider gifts of appreciated long term capital gain stock in a listed company. The transfer of long-term shares to charity is deductible at fair market value, subject to a limitation of 30% of adjusted gross income, and the charity’s exempt status shelters the gain when it sells the stock.
The estate tax is still with us, although the exemption levels are high enough that it affects only very large estates. 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. If the taxpayer is 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 2018. Year-end donations of publicly traded stock require earlier action.
Wealthy donors may want to consider the private foundation, which is a created entity subject to special rules, albeit it enables contributions to be deducted currently even though the ultimate working charity doesn’t get assets until some later date when funds are distributed by the private foundation.
A highly useful, less complicated vehicle that can also achieve current deductions while deferring payments to operating charities is the donor advised fund.
A charitable remainder trust is a tax-exempt irrevocable trust that creates a potential income stream to you and/or other beneficiaries with the remainder of the donated assets going to your favorite charity or charities. They can sell appreciated donated property without incurring gains tax. The income interest reduces the income tax deduction because it does not go to charity. The value of the remainder that eventually passes from the trust to the charity yields an immediate income tax deduction upon funding the trust. Assets in the trust are also exempt from estate tax. There are many choices to be made in designing a remainder trust, including the payout rate to the donor or other beneficiary of the income interest.
Planning for the Business Taxpayer
There’s new emphasis on controlling business income by planning capital expenditures.
In general, for 2018, taxpayers are entitled to opt to expense $1 million of equipment. This Section 179 benefit begins to phase out for larger taxpayers, those with equipment additions in excess of $2 ½ million.
There is also a “bonus depreciation” provision which generally allows the taxpayer to write off 100% of tangible property if the recovery period is 20 years or less (so it would not apply to building structures per se).
Basis is reduced first by the Section 179 expensing election, then this 100% bonus depreciation provision, then the normal depreciation rules.
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).))
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 the cut-backs weren’t focused on the tax rules associated with pension/profit-sharing plans. So owners of closely-held businesses may still want to maximize pension/profit-sharing plan contribution deductions even in this reduced tax rate environment following the 2017 Tax Cuts and Jobs Act.
One of the planning possibilities with many C corporations relates to qualifying to exclude all or part of the gain on the stock under Section 1202. The focus is on operating businesses whose real estate holdings are limited. Hotels don’t fit within these rules. These are termed “small businesses” but they can be fairly large. Assets must not exceed $50 million. A number of detailed rules have to be satisfied but planning under the C corporation approach to your business may well need to include planning to eventually exclude gain on the disposition of the company.
On the loss side, there is also the possibility that a portion of loss on the sale of corporate stock will qualify for ordinary loss treatment – $50,000 maximum on a single return and $100,000 maximum on a joint return. Section 1244 stock is another important topic with its own set of rules.
Your business may be in a closely held corporation or multiple entities. Your real estate, including realty used in your business, may be in a partnership or LLC even if your operating business is in one or more C corporations.
Within your year-end planning, also consider the longer term, including continuity of management and finances. Typically, a highly successful closely-held corporation will think first of family members for continuity of management and long-term wealth within the family; secondly, they will often look to existing management and ask if such parties
could transition into ownership roles. Part of this planning includes the likely, and the unlikely; e.g., what if health becomes an issue or it becomes important to move the family?
Such planning should include the near-term, an intermediate time frame. (typically 3-5 years) and the long-term.
Part of such planning can also encompass identifying likely buyers, including listed companies.
The more sophisticated the buyer, the more likely the questions and needs may be more stringent; e.g., whether you’ve filed in all the states and cities whose rules may say you have “nexus.” Often these rules may entail altering the facts to avoid nexus It is important to timely file wherever required.
Year-end planning is often a good time to focus on the longer-term, thinking about what is working well and may be expanded, and what is not working well and needs to be cut back.
Planning for the Flow-Through Entity
Flow-through business income from an S corporation or partnership will be taxed at a lower rate in 2018 than in the past. However, the general context remains one of looking at year-end planning with an eye to deferring income and accelerating deductions.
Planning for the 20% of Business Income Deduction
Beginning in 2018, this new deduction is basically 20% of business income or if less, adjusted taxable income. ((Section 199A.)) Current law provides for this benefit to run through 2025.
Basic planning here may encompass maximizing year-end business income receipts and minimizing business expenses to maximize the business income component or planning to increase the adjusted taxable income component of the calculation. The latter may entail minimizing the current year’s deductions for benefit plan contributions, even charitable donations and mortgage interest payments on the residence.
There are often scenarios requiring wages and/or capital expenditures to qualify for the tax break, and year-end planning may encompass increasing such elements.
Planning may run in the opposite direction; i.e., forgoing or minimizing the 20% deduction in 2018 with the idea of increasing the prospects and measure of the deduction in 2019.
This is an area requiring detailed business records to date as well as projections to year-end, in-depth study and analysis and often action; e.g., the level of any bonuses to control the wage component of the calculation or purchasing more equipment by year end.
The “adjusted taxable income” component of this calculation introduces various planning issues.
Sole proprietorships, partners and shareholders of S corporations may benefit here. The deduction isn’t available to C corporations whose benefit with the 2017 Tax Act focused more on the tax rate reduction. The corporate rate change to a flat 21% actually increased the corporate tax rate at lower levels of taxable income. On the other hand, beginning after 2017, the corporate tax rate doesn’t go above 21% even for personal service companies.
Wage income doesn’t qualify whereas fees as an independent contractor normally qualify; the major exception being that income of certain categories of service providers may not benefit from the 20% deduction – e.g., doctors and lawyers.
Certain types of service providers may not qualify if taxable income exceeds $157,000 or $315,000 on a joint return. These “non-qualifiers” provide services in health, law, consulting, athletics, financial services, brokerage services, or any field if the principal asset is the reputation or skill of one or more employees or owners, or when services involve investing and investment management trading, or dealing in securities, partnership interests or commodities. Engineering and architectural services are mentioned as qualifying.
There is a range of partial qualification starting at the above threshold amounts. So lower levels of taxable income qualify despite arising from services on the above list. Mid-range income earners may qualify for some deduction, and only high income service providers on the non-qualifying list have no benefit.
Among the possible planning and substantiation issues here is proving the character of certain types of payouts from entities; e.g., partnership distributions don’t reduce partnership income whereas guaranteed payments to a partner don’t qualify as income subject to the 20% and they reduce business income that may otherwise be subject to the 20% deduction. Whether payments to a shareholder of an S corporation are wages or dividends is a similar issue.
Planning may not only include the level of say equipment additions to make by year-end but contemplating whether to opt to accelerate deductions for equipment additions.
Planning may encompass the spectrum of issues over which the taxpayer has some control because of the breadth of issues affecting the taxable income component of this deduction. We expect the taxable income limitation to apply frequently, yet every taxpayer’s situation is different.
There is an aggregation election to weigh with respect to the newly proposed regulations under Section 199A.
Planning here will often be complicated. See generally Rojascpa.com, “Articles,” “A Planning Introduction to the 2017 Tax Act – The 20% of Business Income Deduction,” as well as our discussion of the topic within “A Planning Introduction to the 2017 Tax Act-The Overview,”
Net Operating Losses
The 2017 Act changes generally don’t allow 2018 net operating losses to be carried back. Specifically, the new rule applies to losses arising in taxable years ending after December 31, 2017. The losses carryover indefinitely but the carryover cannot offset more than 80% of income, so even full offset of deductions may be limited.
We expressed concerns about the fairness, potential harshness of this new limitation on net operating losses. See Rojascpa.com, “Net Operating Loss Carryback Repeal Isn’t Getting the Attention It Deserves.”
Another potentially harsh rule that may be mitigated with planning is a new rule saying larger non-corporate losses go directly to net operating loss carryover classification rather than offsetting current income. This rule applies when business losses are
$250,000, or $500,000 in a joint return. The passive loss rules apply prior to this concept. This problem should be considered in year-end planning and in making election decisions in the return.
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.
There are complex tax rules that generally limit the ability of a business owner to transfer the benefit of net operating losses to a new buyer.
The additional .9% Medicare tax applies to employees and the self-employed generally at levels of $200,000 if single or $250,000 if filing jointly. The self-employed, for example, may plan toward avoiding this tax by controlling billing and paying additional expenses near year end.
Gift and Estate Tax Planning
The IRS has proposed regulations aimed at concerns when the person makes major gifts during 2018-2025 and then passes away when the transfer tax exemptions are scheduled to revert back to old, lesser levels.
The proposed regulations should help taxpayers who make large gifts during 2018-2025 when the exemption levels are high. Even if the transfer tax exemption reverts to old levels, estates are to be protected by the higher exemptions claimed. ((Reg-106706-18, 11/20/18.))
It is only the larger estates, assets exceeding $22.36 million for couples and $11.18 million for single taxpayers, that actually incur estate tax under current law.
The 2017 transfer tax exemption was $5.49 million and $10.98 million for a married couple. ((Cont. Rep to the 2017 Tax Cuts and Jobs Act, p. 307-316.)).
The increased exemption from estate and gift tax applies after December 31, 2017 and before January 1, 2026, so technically this benefit is temporary. ((Conf. Rep., p. 316 to the 2017 Tax Cuts and Jobs Act.)) The exemption from generation-skipping tax also increased temporarily.
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 its many strategies and complexities, is very much with us.
The gift tax is also very much with us.
If your estate is large enough to actually incur tax under the higher exemption amounts, you may also want to consider such planning techniques as family limited partnerships. The planning goal with the family limited partnership usually focuses on reducing valuations when the assets would otherwise trigger estate tax, or gift tax if given during one’s lifetime.
The transfer of assets expected to appreciate to a GRAT – grantor retained annuity trust
– is another technique that can potentially transfer appreciation to your family free of estate tax or gift tax.
The new proposed regulations are a positive, current consideration in estate planning even though they relate to the post-2025 period.
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 basics of estate planning are still with us. One needs to have in place living trusts, wills, powers of attorney, medical directives, etc.
The legislative changes in late 2017 affecting 2018 were major, both in terms of rate changes, new concepts, and the deletion of deductions. Most of the changes were even temporary; much of prior law springs back after 2025. The effect the elections of November 2018 will have upon any eventual tax legislation is uncertain. The environment is one of keeping a watchful eye on developments, including IRS interpretations of the 2017 Act, while also planning within the law as it is currently.
The ranges of possible change in taxable incomes per year are particularly dramatic in 2018 considering old and new tax planning strategies.
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 informationai 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.