EDITOR’S NOTE: This column details changes under the new federal tax reform low. Our Point/Counterpoint columns in this issue offer a debate on the reforms’ effect on the economy.
By PHILIP SPEICHER
The Tax Cuts and Jobs Act, signed into law by the president on Dec. 22, 2017, brought a long list of modifications to the Internal Revenue Code, changing the way both businesses and individuals are taxed. The central focus of the act is directed toward businesses and business owners, but it also contains several significant changes and tax reductions for individuals, as well.
Before discussing the new changes, it is important to know two concepts of business tax: 1) double taxation, and 2) pass-through taxation. Under the double-taxation model, a corporation files its own tax return and pays tax on its net income. The shareholders later pay a second tax when the corporation distributes the income to the shareholders as a dividend. Virtually all large businesses (think Apple), but also some small businesses, operate under a double-taxation model.
Under the pass-through model, the corporation files a tax return but does not pay any direct tax on the net income. Instead, the business income is “passed through” to the owners, who report that business income on their personal return and pay tax on that income immediately, even if it is not distributed to them. The trade-off is that they do not pay any additional tax when the income is later distributed. The vast majority of small and family-owned businesses operate under the pass-through model.
Business Tax Changes
The act brings changes to both double-taxation businesses and pass-through businesses, generally reducing taxes for both. For double-taxation business, the top corporate tax rate is reduced from 35 percent to 21 percent.
One of the most significant changes the act brings to business taxation is a new deduction for pass-through businesses. Since there is no corporate tax rate to reduce for pass-through businesses, the act instead provides a 20 percent deduction against pass-through income (subject to certain limitations and exceptions). In other words, business owners will now pay tax on only 80 percent of the business’s pass-through income instead of 100 percent. This is the “Qualified Business Income” (or “QBI”) deduction. The QBI Deduction is available to owners of S Corporations, partnerships, sole proprietorships, and others.
There are some important exceptions to the QBI Deduction. Business owners who make too much money or employ too few employees may have their QBI deduction reduced or denied altogether. For example, if a business owner makes more than $157,500 (or $315,000 if married filing joint), but the business employs very few people, the business owner may be required to pay tax on more than 80 percent of the net business income. The purpose of this limitation appears to be to incentivize businesses to create additional jobs and/or increase wages. In addition, professionals such as doctors, lawyers, CPAs, financial advisors, entertainers and athletes, are also subject to reduction or elimination of the deduction if their income exceeds $157,500 ($315,000 for married filing joint).
- There are a number of additional changes affecting businesses, including:
- Increased Section 179 expensing and temporary 100 percent first-year depreciation on the purchase of qualifying business assets.
- A tax credit for businesses that provide paid leave to employees for Family and Medical Leave under FMLA.
- Denial of any deduction for settlement of a sexual harassment claim if the settlement includes a nondisclosure agreement. Temporary deferral of tax on capital gains if the gains are reinvested in a Qualified Opportunity Zone.
- Cash distributions following conversion of an S corporation to a C corporation are now partially taxable as dividends.
- Many changes for multi-national businesses, including a substantially reduced tax rate for repatriation of foreign assets held overseas.
- Repeal of the Corporate Alternative Minimum Tax.
- Elimination of the Domestic Production Activities Deduction (replaced by the QBI Deduction).
Individual Tax Changes
The Act brings with it several changes to various individual income tax provisions. The Act shuffles several pre-Act tax benefits to individuals, increasing some and reducing others.
First and foremost, the tax brackets are changed, with an overall reduction in both the tax rates and a larger portion of income falling within the lower brackets. In addition, the standard deduction is significantly increased to $12,000 for single filers, $18,000 for household filers, and $24,000 for married filing joint filers, which is intended to greatly reduce the number of taxpayers who itemize their deductions.
The deduction for personal exemptions is eliminated and replaced with an increase in the child tax credit to $2,000 per child. The Act also provides an additional tax credit for certain non-child dependents. For taxpayers with children, the increased child tax credit is generally worth more than the lost personal exemption deduction.
With respect to itemized deductions, the State and Local Tax deduction is now limited to $10,000 (married filing joint), and the mortgage interest deduction is limited to $750,000 of mortgage debt. However, all pre-Act mortgages are grandfathered. In other words, taxpayers who previously purchased homes with mortgages greater than $750,000 will still be allowed to deduct their full mortgage interest. In addition, any refinance of a grandfathered loan will continue to be treated as a grandfathered loan.
Additional changes to individual income taxes include:
- Increased deductibility of medical expenses.
- Increased deductibility of charitable contributions.
- Alimony is no longer deductible by the payor or taxable to the payee.
- The “Pease” limitation on overall itemized deductions is eliminated.
- Members of Congress are no longer allowed to take a deduction for living expenses while away from home.
- The Affordable Care Act penalty for failing to have health insurance (the “shared responsibility payment”) is eliminated.
- The Alternative Minimum Tax exemption amount is increased and indexed for inflation.
Finally, the Act introduces changes to tax-exempt organizations, including:
- An excise tax on excessive compensation paid to executives in tax-exempt organizations.
- An excise tax on the investment income of private colleges and universities with at least 500 students and assets greater than $500,000 per student.
Philip Speicher is a shareholder of the Mathis, Marifian & Richter law firm serving Metro East. Since beginning his career in 2004, he has extensive experience in litigation of tax disputes before the U.S. Tax Court and in representing both businesses and individuals in IRS audits.