The newly-enacted tax reform law, dubbed the “Tax Reform and Jobs Act,” will deliver major changes to the U.S. Tax Code. While it’s not possible to examine all of them in one (or even several) blog posts, let’s take a look at some of the changes most likely to affect individuals and small businesses, including pass-through businesses.
Change in Taxation of Pass-Through Businesses
Pass-through businesses include sole proprietorships, partnerships, and S corporations. The term also encompasses limited liability companies that are taxed as partnerships or S corporation. Prior to the change in the law, owners of such businesses were taxed on the business’s income at their own individual tax rates, which could be as high as 39.6 percent. Even if the income was rolled back into the business, not distributed to the owner, it had to be reported on the owner’s personal income tax return.
The new law provides owners of pass-through businesses with a 20 percent deduction for tax years beginning in 2018 and ending in 2025. In addition to individual business owners, trusts and estates that own pass-through businesses may claim this deduction as well. The 20 percent deduction applies only to “qualified business income” (QBI) which includes business income other than income from investments, and excludes investment interest income, capital gains, foreign currency gains, commodities gains, and wages and dividends.
Not all pass-through businesses are eligible for the deduction, though. Specified service businesses, which includes medical, legal, consulting, and financial services, investment firms, and brokerages, are excluded. This would seem to eliminate the benefit for many small business owners, but there is one important exception to this exclusion. Joint filers whose income is less than $315,000, and other taxpayers with income less than $157,500, may claim the full deduction on income from specified service businesses. For taxpayers above those income thresholds, the deduction phases out.
Owners of those businesses who do qualify for the deduction will have a maximum effective tax rate of 29.6 percent.
Changes for Individual Taxpayers
Most individual taxpayers will also pay less tax than before the Act took effect. There are still seven tax brackets for individuals and joint filers, though the levels of income and tax rates are somewhat different. The lowest bracket is still 10 percent, and the top income level for that bracket is unchanged, at $9,525 for individuals. In general, though most people will find themselves in a lower tax bracket. The top tax bracket, now reserved for those individuals with income over $500,000, is 37 percent, down from 39.6 percent.
The standard deduction, which is indexed for inflation, will almost double from $6,350 to $12,000 for individuals and from $12,700 to $24,000 for married couples. The increased standard deduction, along with the lowering of tax rates and widening of most tax brackets, is intended to offset the elimination of personal exemptions by the Act.
Other changes that may affect individuals:
- Alternative Minimum Tax (AMT): For taxable years beginning after December 31, 2017, and ending prior to January 1, 2026, the exemption amount and exemption thresholds are increased for single and joint filers, potentially exposing fewer taxpayers to the AMT.
- State and Local Tax (SALT): The deduction for state and local taxes (SALT) on the federal tax return will now be limited to $10,000, or $5,000 for a married individual filing separately. If you were thinking of prepaying income taxes in 2017 to take advantage of the then-current deduction, the Act was one step ahead of you, providing that payments paid for state and local taxes in a taxable year prior to January 1, 2018 for a taxable year beginning after December 31, 2017, would be treated as having been paid on the last day of the taxable year for which the tax was imposed.
- Temporary Decrease in Mortgage Interest Deduction Threshold: Prior to the Act, the home mortgage interest deduction allowed deductions on interest on up to $1,000,000 of acquisition indebtedness. This figure has been temporarily lowered to $750,000 through December 31, 2025, at which time the previous threshold of $1,000,000 will be reinstated, regardless of when the debt was incurred.
- Temporary increase in Child Tax Credit: Under the Act, the Child Tax Credit (CTC) will be increased from $1,000 to $2,000 per child, and $1,400 of that amount will be refundable. There will also be a $500 credit (nonrefundable) for dependents other than qualifying children. The CTC will also begin to phase out at a higher income threshold than previously. Like many of the other changes imposed by the Act, these changes will expire on December 31, 2025.
- Temporary Doubling of Estate, Gift, and GST Tax Exemption: Good news for those with wealth they want to transfer to their children or grandchildren: for gifts and generation-skipping transfers made after December 31, 2017 and before January 1, 2026, as well as for estates of individuals who pass away during that time span, the estate, gift, and generation-skipping tax (GST) tax exemptions are doubled. The Act doubles the estate, gift, and GST tax exemptions from $5 million to $10 million (adjusted for inflation after 2011) for estates of decedents dying, generation-skipping transfers, and gifts made after December 31, 2017 and before January 1, 2026.There is no provision for ultimate repeal of the estate, gift, or GST taxes. As of January 1, 2026, those exemptions will revert to the level (indexed for inflation) at which they were before the Act took effect
- Effective Repeal of ACA Individual Mandate: The Affordable Care Act (ACA) required individuals to maintain a minimum level of health insurance or face a penalty. The Act does not directly repeal this mandate, but does so essentially by reducing the penalty for not carrying insurance to zero. Note that this change does not take effect until January 1, 2019, unlike most changes imposed by the Act.
- Deductibility of Alimony: Under current law, alimony payments are deductible to the payer and taxable as income to the recipient. That will also change on January 1, 2019, and will not affect orders for alimony payment or modification that are entered in 2018.
As you may have noticed if you’ve made it this far, many of the changes imposed by the Act have a “sunset” provision, meaning they expire after a certain period of time. The sunset provisions were put in place to limit increases to the federal deficit.
What Taxpayers Should Do Next
The Act has made, and will make, major changes to the federal tax landscape, the entire scope of which may not be made clear for some time. The take-away, however, is that planning you did for your family or business ten, five, or even one year ago may now need revisiting in light of the new legislation. A consultation with your estate planning, business succession, or wealth management attorney can help you take maximum advantage of the new law.
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