Tax Cuts & Jobs Act Update

In our white paper, Tax Reform Near the Finish Line: What’s in the Bill, we summarize the portions of the Tax Cuts & Jobs bill of particular interest to investors, as well as the likely winners and losers under that legislation.

The Senate subsequently agreed to the following changes to its bill during floor consideration and voting:

Full expensing of business capital investments no longer ends abruptly after 2022, but now phases out, reduced by 20% each year through 2026 (entirely phased out in 2027).
The deduction for income earned by business pass-through entities is increased from 17.4% to 23%.
Permit property tax deduction up to $10,000 annually (same as House bill).
Reduce AGI threshold for medical expense deduction from 10% to 7.5% for next two years. (The House bill would eliminate the medical expense deduction entirely.)
The individual alternative minimum tax is not repealed, but the exemption amount is increased so fewer taxpayers are subject. (No changes to corporate AMT.)
Raise tax rate on deemed repatriation of existing foreign earnings from 10% (liquid assets) and 5% (illiquid assets) to 14.5% and 7.5%, respectively.
Permit 529 funds to be used for elementary and secondary education (same as House bill).

After the House and Senate versions are distilled into a single bill, we will update our white paper to incorporate the final provisions.

In the meantime, financial advisors have asked about other parts of the pending legislation that might impact their clients. Following are some of the questions we have received, along with our responses.

Do the bills in their current forms have any negative impact on deferred compensation? Is any negative impact expected?

The initial drafts of the bills would have taxed deferred compensation at such earlier time as the compensation payment was no longer contingent on future services to be provided by the recipient, even if actual payment is deferred beyond that date. Further, the bills would have applied these deferred compensation rules to grants of stock options. However, these changes were dropped from both bills during committee review. The changes could be added back during the process of distilling the House and Senate versions into as single bill, but given the prior rejection of the changes, that addition back seems unlikely.

May businesses continue to claim deductions for items such as meals with clients, business travel, advertising, and marketing materials?

Both bills eliminate the deduction for business entertainment expenses. (Current law permits a business to deduct 50% of such expenses.) The bills do not change the deduction of the other business expenses noted.

Do the bills change the deduction for alimony payments?

The House bill (but not the Senate bill) eliminates the deduction for alimony payments. The House bill makes clear that alimony payments also are no longer includable in the recipient’s taxable income.

How do the bills affect the individual mandate for health insurance?

The Senate bill (but not the House bill) eliminates the penalty imposed on people who do not purchase health insurance (the “individual mandate”). This provision is controversial. The non-partisan Congressional Budget Office has concluded that this action will save the federal government over $300 billion in the next decade, but will result in premiums increasing by an additional 10% and 13 million people not continuing their insurance coverage.

Please explain how the bills treat the effect of inflation on the tax brackets.

Both bills change the inflation index used to increase the income levels at which higher tax rates take effect. The bills substitute the “chained” CPI index for the standard CPI index used under current law. “Chained” CPI acknowledges that consumers might switch to less expensive alternative goods when the prices of some goods get too high. (For instance, if the price of beef is too high, consumers may switch to less expensive chicken.) Chained CPI increases less quickly than unchained CPI. As a result, under the bills the income levels will not increase as quickly, potentially forcing taxpayers into higher tax brackets as their incomes increase due to inflation (a process called “bracket creep”).

How will tax loss carryforwards be treated?

Both bills eliminate net operating loss carrybacks. Both bills also make changes to the treatment of loss carryforwards. The House bill provides that loss carryforwards may offset only up to 90% of taxable income in any given year. The Senate bill likewise permits loss carryforwards to offset only 90% of taxable income through 2022, and 80% of taxable income thereafter. The Senate bill allows individuals (not corporations) to claim net losses up to $250,000 annually; losses over that amount are subject to the new carryforward rules. Under both bills, unused losses may be carried forward indefinitely. The rule eliminating loss carrybacks applies to losses arising in 2018 and later years. The 90% income limitation applies to carryovers used in 2018 and later years.

Does the House or Senate bill change the status of grantor trusts?

The bills make no direct change to the tax treatment of grantor trusts. Grantor trust income is taxed to the grantor as if the trust does not exist and the grantor earned the income directly. So, to the extent the bills reduce the tax rates applicable to the grantor’s income, the reduced rates apply as well to the trust income flowing through to the grantor’s return.

Under the bills, non-grantor trusts (which, unlike grantor trusts, pay their own taxes) remain taxable at the highest rate on income over $12,500. The Senate bill reduces the top tax rate from 39.6% to 38.5%; the House bill does not reduce the top tax rate.

Andrew H. Friedman is the principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He and his colleague Jeff Bush speak regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. They may be reached at www.TheWashingtonUpdate.com.

The authors of this paper are not providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities).

Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement. Copyright Andrew H. Friedman 2017. Reprinted by permission. All rights reserved.

Tax Cuts & Jobs Act Update

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