The Tax Cuts and Jobs Act (TCJA) was signed into law late last year. This article briefly summarizes a few important features of the TCJA that will affect many taxpayers. The TCJA made three significant changes to prior law:
- significantly decreasing the corporate income tax rate;
- creating a new deduction for certain business income flowing from pass-through businesses such as partnerships and S-corporations; and
- reduction in individual tax deductions.
Decrease in Corporate Income Tax Rate to 21 percent
The potential for savings comes from a dramatically lower corporate income tax rate. Beginning in 2018, C-corporations will pay a flat rate of 21 percent (down from 35 percent). In addition, the TCJA repealed the corporate alternative minimum tax. Individuals who receive dividends paid from a C-corporation are still subject to the 20 percent preferred dividend rate (the second level of the corporate “double-taxation” regime). However, the dividend tax is only incurred when the corporation chooses to pay dividends to shareholders. Businesses that instead opt to retain earnings for growth are subject only to the 21 percent income tax rate while they may defer the tax on dividends into the future.
Income Tax Relief to Some Pass-Through Owners
Tax relief was extended to owners of “pass-through” entities (including sole proprietorships, partnerships, LLCs that are treated as sole proprietorships or as partnerships for tax purposes, and S corporations).
Under prior law, net taxable income from so-called pass-through business entities was simply passed through to owners and taxed at the owner level at standard rates.
First, income allocated from a pass-through entity will be subject to lower individual income tax rates. The top individual rate decreased from 39.6 percent to 37 percent.
Second, the TCJA provides a new deduction for “qualified business income” (QBI), most often received from a pass-through entity. QBI generally includes the net amount of domestic ordinary income generated from a taxpayer’s business during the year. Investment income (e.g., interest, dividends, and capital gains) do not qualify. A partner or shareholder is eligible for a deduction of up to 20 percent of QBI reported on his or her individual return.
However, the QBI deduction is limited in a number of ways. The QBI deduction generally cannot exceed the greater of the noncorporate pass-through entity owner’s share of: (1) 50 percent of amount of W-2 wages paid to employees by the entity during the year or (2) the sum of 25 percent of W-2 wages plus 2.5 percent of the cost of qualified property. Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year-end and used by the business at any point during the tax year for the production of qualified business income. Under an exception, the W-2 wage limitation does not apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint-filers.
The QBI deduction is generally not available for income from specified service businesses, such as most professional practices. Under an exception, the service business limitation does apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint-filers.
The W-2 wage limitation and the service business limitation do not apply as long as your taxable income is under the applicable threshold. In that case, you should qualify for the full 20 percent QBI deduction.
Reduction in Individual Tax Deductions
Under the TCJA, it is estimated that less than 14 percent of taxpayers will continue to use itemized deductions rather than the increased standard deduction after changes such as the allowance for up to $10,000 of state and local tax deductions and the retention of the medical expense deduction. That reduces the number of itemizers by more than 50 percent from 2017 and means that more than 85 percent of households will claim the standard deduction.
One of the biggest impacts for those taxpayers who use the standard deduction starting in 2018 is that most charitable contributions will have zero tax benefit. The higher standard deduction also means that most households will often not get the full tax benefit of their charitable gifts. Given that high income taxpayers previously received an effective federal and state tax subsidy of approximately $40 for every $100 they give to charities, this lost deduction adversely impacts both charities and taxpayers.
If you do not have a large mortgage (i.e., exceeding $14k/year) and/or large medical expenses (i.e., exceeding 7.5 percent of your adjusted gross income), it is likely that you will not receive a full tax benefit from charitable gifts. If you’re in such a scenario, then perhaps the most valuable year-end tax planning strategy is to accelerate charitable contributions before the end of 2018. One of the most efficient ways to exploit this strategy is via a donor-advised fund where the tax deduction is immediate but the actual timing of the gifts to the targeted charities can be years in the future.
Another technique that will likely be advantageous in future years is to lump several years of charitable contributions into a single calendar year, a technique that is being called “charitable bunching.” For example, there will be a significant tax incentive, under the new law, to give $50,000 to charity in one calendar year rather than $10,000 per year for five years.
Over the next few months, we will see many more developments about other changes in the new tax law with more details.