THE NEW TAX LAW
Key Changes Implemented by the 2017 Tax Cuts and Jobs Act
January 5, 2018
George Adams CPA MBA
Introduction
The 2017 Tax Cuts and Jobs Act was signed into law on December 22, 2017 and represents the most significant change in tax law since 1987. Most taxpayers will see a reduction in taxes in February, 2018 as a result of lower tax withholdings applicable to paychecks. Small business owners will also enjoy a substantial tax cut and more favorable treatment of business investments in equipment and vehicles. Finally, the new law simplifies individual tax returns for many people. Under the new law it is estimated that only 10% of taxpayers will itemize their deductions on Schedule A, compared to 30% under prior law.
Most of the changes to individual tax laws will expire in 2026.
It is likely that a technical corrections bill will be passed soon to fix various errors and inconsistencies in the new law.
Here is a brief summary of key changes for individuals and business owners:
Major Changes for Individuals
(1) Lower Tax Brackets
The new law lowers almost all tax brackets applicable to taxable income reported on Form 1040 as follows:
| 2017 Rate | New Rate Starting in 2018 |
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|
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| 10% | |
| 15% | 12% |
| 25% | 22% |
| 28% | 24% |
| 33% | 32% |
| 35% | 35% |
| 39.6% | 37% |
(2) Personal Exemption Deduction is Eliminated
The deduction for personal exemptions ($4,050 for 2017) is eliminated starting in 2018. While this will negatively affect families with large numbers of children there will be an offsetting benefit from the increased child tax credit (discussed below.)
(3) Standard Deduction Increased
Starting in 2018 the standard deduction used by taxpayers who do not itemize will increase to $12,000 for individuals and $24,000 for joint tax returns. This change will reduce the number of people who itemize and have to file Schedule A.
(4) New $10,000 Limit on State and Local Tax Deductions
Starting in 2018 for people who do itemize there will be a new $10,000 limit on deductions for state income taxes and property taxes.
(5) Miscellaneous Itemized Deductions Eliminated
Effective Jan. 1, 2018 miscellaneous itemized deductions subject to the 2% of adjusted gross income floor will be eliminated. This category of expense included deductions for so-called unreimbursed employee expenses, investment advisory fees, tax preparation fees, and safety deposit box rentals.
Some people erroneously interpreted this change to mean that business owners would no longer be able to deduct business expenses. FALSE. Business expenses may continue to be claimed on Schedule C, or other tax forms for companies such as LLC’s and S corporations. Only miscellaneous itemized deductions claimed on Schedule A have been deleted for 2018 and later years.
(6) Tougher Kiddie Tax Rules Apply in 2018
The so-called ‘Kiddie Tax’ applies to the unearned income of dependent children under age 19 and dependent college students under age 24 at December 31 of each tax year. The unearned income of these dependents used to be added to their parents taxable income, resulting in an additional ‘Kiddie Tax.’ The tax is reported on IRS Form 8615. Note that this tax does not apply to earned income such as wages and salaries.
The new tax law will subject unearned income of dependents to trust income tax rates starting in 2018. Unearned income in excess of $12,500 will be taxed at the highest rate of 37%.
(7) Larger Child Tax Credit
For 2018 and future year tax returns there will be a larger child tax credit for children under age 17 at December 31. The current tax credit of $1,000 per qualifying child has been doubled to $2,000. Further, this credit will be available to higher income taxpayers. Previously, the credit was phased out if adjusted gross income on a joint tax return exceeded $110,000. Starting in 2018 the phase-out threshold begins at the more generous limit of $400,000.
(8) New $500 Credit for Other Dependents
In 2018 there will be a new $500 tax credit for other dependents including dependent children over age 16 and parents claimed as a dependent.
(9) New Limits on Deductible Mortgage Interest
For new mortgages taken out after December 15, 2017 deductible mortgage interest will be limited to interest attributable to $750,000 of debt. Interest on debt over this amount is non-deductible. Mortgages taken out prior to this date remain subject to the former $1 million cap.
(10) Interest on Home Equity Indebtedness Is No Longer Deductible
Starting in 2018 interest expense for home equity loans will no longer be allowed as an itemized deduction. This limitation applies to home equity loans used for any purpose other than improving your home. If a home equity loan is used for home improvements then the interest remains deductible subject to the statutory limit.
(11) Charitable Contribution Deductions Increased
In 2018 and later the limit for charitable contributions is increased to 60% of adjusted gross income from 50%. This favorable change may be especially helpful for people using a Charitable Remainder Trust. (See my January 2018 article in the Maine Eagle Magazine for a discussion of the many tax benefits of Charitable Remainder Trusts.)
(12) Increased Deduction for Medical Expenses
For 2017 and 2018 medical costs greater than 7.5% of adjusted gross income may be claimed as itemized deductions. Previously the limit was 10%. The old limit returns in 2019 and later. Crazy but true!
(13) Health Care Coverage Penalty Repealed
For 2019 tax returns filed in 2020 the penalty for not having qualifying health insurance coverage is repealed. The penalty remains in effect for 2018 tax returns and is the greater of 2.5% of adjusted gross income or $695 per adult.
(14) Tax Treatment of Alimony Changed
For divorce agreements executed after December 31, 2018 alimony is no longer deductible by the payer and no longer taxed to the recipient. This change affects 2019 tax returns filed in the year 2020. It may be possible to modify prior year agreements to adopt this new rule.
(15) Tax Treatment of Net Operating Losses Changed
For individuals net operating losses exist when allowable deductions exceed income. See IRS Publication 536.
Starting in 2018 net operating losses may be carried forward to future tax years indefinitely and may offset up to 80% of taxable income. Previously, these losses could offset 100% of taxable income. Further, most net operating loss carrybacks are eliminated.
(16) Method Used to Index Tax Brackets Changed
Many dollar-defined elements of the tax law including the standard deduction and income tax brackets subject to the seven different tax rates are annually indexed for inflation. The purpose of indexing these amounts is to neutralize the effect of inflation, which has averaged 1.7% annually for the past few years.
Starting in 2018 the method used for indexing will change to so-called ‘chained CPI.’ The effect of this change is likely to slow the increase in indexed amounts, and in effect is a fairly small stealth tax increase.
(17) Important Things that did NOT Change:
Despite persistent rumors and misinformation, here is a list of important deductions that remain in effect and were not changed by the new tax law:
(A) Favorable Treatment of Capital Gains Remains
No change was made to the favorable tax treatment of capital gains and qualified dividend income. Further, the zero percent tax rate on capital gains remains in effect and applies to taxpayers with 2017 taxable income of less than $38,600 (individuals) and $77,200 (joint returns.)
(B) Student Loan Interest
Student loan interest remains deductible up to the $2,500 limit.
(C) Business Expenses Remain Fully Deductible
Personal unreimbursed employee expenses previously allowed as a miscellaneous itemized deduction have indeed been eliminated. But business expenses incurred by sole proprietors (Schedule C filers) and other business owners remain fully deductible. Restrictions have been placed on deductions for business meals.
Major Changes for Business Owners
(1) New 21% Flat Tax Rate for C Corporations
Starting in 2018 Subchapter C Corporations (NOT S Corporations) will be subject to a flat 21% corporate income tax rate. Previously there were graduated tax rates from 15% to 35%. Note that C Corporations remain subject to a double tax: taxes are paid when the company earns profit and again (a second time) when profit is paid out to owners as either salary or dividends. Unlike S corporations, owners of C corporations are not allowed to take tax-free distributions of company profits.
(2) New 20% Deduction for Pass-Through Entities
This is probably the most beneficial change offered by the new tax law to owners of S corporations, limited liability companies and sole proprietorships. New IRC Section 199A allows for a 20% deduction subject to the following limits:
|
(A)
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For some industries the 20% deduction is phased out if the business owner’s adjusted gross income exceeds $315,000 for a joint tax return.
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(B)
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The deduction is further limited to the lesser of 20% of business income or 50% of total wages paid to all employees.
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(C)
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The 20% deduction is claimed on the business owner’s personal tax return and is NOT an ‘above the line’ deduction. This means the deduction does not reduce adjusted gross income. |
The 20% pass-through deduction calculation can be quite complex and is best understood using flowcharts. The above information is merely a brief summary of a complex matter.
Because business profits, not owner salary, are subject to this special deduction there will be an incentive to minimize owner compensation in order to maximize business profit and the 20% deduction. I predict the IRS will increase its scrutiny of the compensation business owners pay themselves. The controversial topic of what is ‘reasonable compensation’ for owners of S corporations is bound to acquire even more importance because of this major change in the tax law.
For IRS guidance on the issue of what is reasonable compensation see:
For comprehensive data on comparable pay based on occupation and location see the following resource provided by the Economic Research Institute:
Another effect of this change is to offer lower tax rates for self-employed business owners compared to traditional employees. Given current conditions in many labor markets it is a wonderful thing to own your job and not be an employee. The new tax law offers a tax incentive for people to start their own businesses, or at least have a second source of income from a side business.
(3) Domestic Production Deduction Eliminated
The Domestic Production Deduction (old IRC Section 199) has been eliminated for 2018 and later. In many ways the new 20% pass-through deduction is modeled on this prior year deduction, which is still available for one last time in 2017.
(4) Increased Depreciation for Business Autos
Passenger cars (not SUV’s or trucks) will qualify for a higher first year expense limit of $10,000. The prior limit was $3,160. Note that vehicles with a gross vehicle weight rating of 6,000 pounds or more may qualify for even more generous depreciation amounts.
(5) Bonus Depreciation Increased and Expanded
This is another major win for business owners. Bonus depreciation of business assets has been increased under the new law to 100% of the cost of the asset. This applies to business assets placed in service after September 27, 2017 and therefore applies to 2017 tax returns filed in 2018. This provision begins to expire in 2023. Further, bonus depreciation can now be claimed on used assets. Under prior law the asset had to be new to qualify.
(6) Section 179 Expense Increased to $1 Million
This is another major victory for business owners, who may choose to expense business assets up to $1 million. This applies to assets that are financed with a bank loan as well as assets purchased for cash.
(7) Cash Method of Accounting Available to More Businesses
IRC Section 448 was modified by Act Section 13102 so as to permit businesses with average annual gross receipts of $25 million or less to use the cash method of accounting. The prior limit was $5 million.
Under the accrual method of accounting billed but uncollected revenue in the form of accounts receivable is taxable, creating phantom income. This forces the owners of pass-through entities using the accrual method to pay tax on income they have not yet physically received, an outrageous absurdity.
All business owners of pass-through entities should review the method of accounting used by their company and take advantage of the new law. Use IRS Form 3115 to obtain automatic IRS consent to a change in method of accounting from accrual to the cash basis method.
Further Resources
(1) Full text of the new law:
https://www.congress.gov/bill/115th-congress/house-bill/1/text
(2) 2018 income tax rates and brackets:
http://www.cpapracticeadvisor.com/news/12387106/2018-irs-income- tax-rates-and-brackets-tax-reform
(3) Comprehensive analysis by Thomson-Reuters of the new law:
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
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Brewer, Maine 04412-2339
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