On Friday, December 22, 2017, the President signed into law the tax reform legislation that had been referred to as the “Tax Cuts and Jobs Act” (TCJA). Key provisions of the report affecting individual taxpayers include lower tax rates, higher standard deductions, and limitations on certain itemized deductions, such as state and local taxes. Key provisions of the report affecting corporations include a reduced flat 21% tax rate and repeal of the alternative minimum tax. A key provision of the report affecting pass through entities is allowing certain partners and shareholders to deduct 20% of their income from pass through entities. The legislation also includes increases in certain property expensing and depreciation limits as well as changes to accounting methods. It is important to note that most individual provisions in the bill expire after December 31, 2025. Most corporate provisions in the bill are permanent, while some other business provisions expire after December 31, 2025.
TAXATION OF INDIVIDUALS
- Tax rates: The new law lowers tax rates for individuals and adjusts the bracket amounts. The top individual rate will be 37% for joint filers with more than $600,000 of taxable income and single (and head of household) filers with more than $500,000 of taxable income. For 2018 through 2025, the tax rate brackets are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Estates and trusts will only be taxed at the 10%, 24%, 35% and 37% rates, with the 37% rate applying to taxable income over $12,500.
- Standard deduction: The standard deduction will be $24,000 for joint filers, $18,000 for head of household filers and $12,000 for single filers (up from 2017 amounts of $12,700, $9,350 and $6,350, respectively). The additional standard deduction for the elderly and blind are retained.
- Personal exemptions: The personal exemptions, including exemptions available for qualified dependent children and relatives, are repealed through 2025.
- Alternative minimum tax: The alternative minimum tax system is retained, but exemption amounts, as well as the thresholds for phasing out exemptions, are significantly increased. These figures will be indexed for inflation in future years. The individual AMT exemption amounts have been increased to $109,400 for joint filers and $70,300 for single filers for 2018.
- Child tax credit: The Child Tax Credit is increased to $2,000 per qualifying child (doubled from $1,000 per qualifying child), with up to $1,400 being fully refundable. An additional $500 credit may be available for other non-child dependents. The Credit begins to phase out for joint filers with adjusted gross income exceeding $400,000 and single filers with adjusted gross income exceeding $200,000, respectively.
- Medical expenses: The medical expenses itemized deduction is made more available for taxpayers under age 65 by reducing the adjusted gross income (AGI) floor for 2017 and 2018 to 7.5% for all taxpayers. The threshold previously was 10% of AGI for taxpayers under age 65.
- State and local taxes: The itemized deduction for state and local taxes has been limited to $10,000 for the sum of (1) real property taxes, (2) personal property taxes, and (3) either state or local income taxes or state and local sales tax.
- Mortgage interest: The itemized deduction for mortgage interest has been reduced to only permit the deduction of interest on acquisition indebtedness not exceeding $750,000. Debt incurred on or before December 15, 2017, is grandfathered under the previous law that allows interest paid on acquisition indebtedness of up to $1 million. The additional interest deduction for home equity indebtedness is repealed through 2025.
- Charitable contributions: The adjusted gross income limitation for cash contributions to certain charitable organizations is increased to 60% of AGI. No charitable deduction is allowed for payments made in exchange for athletic seating rights (previously able to deduct 80% of amounts paid).
- Casualty and theft losses: This itemized deduction is repealed through 2025, but it is preserved, with certain modifications, for losses incurred in federal disaster areas.
- Miscellaneous itemized deductions: All miscellaneous itemized deductions subject to the 2% adjusted gross income floor have been repealed through 2025, including miscellaneous itemized deductions for investment fees/expenses, tax preparation fees, and unreimbursed employee business expenses.
- “Pease limitation”: The overall limitation on itemized deductions has been repealed through 2025.
- Section 529 plans: The list of qualified expenses for Section 529 plans is expanded to include tuition at an elementary or secondary public, private or religious school, plus home schooling expenses, for up to $10,000 per year.
- Roth IRAs: The rule permitting taxpayers to recharacterize a Roth IRA back into a traditional IRA after a conversion is repealed.
- Moving expenses: The deduction for moving expenses is repealed through 2025, except for members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station. The exclusion from gross income and wages for qualified moving expense reimbursements is also repealed.
- Alimony: For any divorce or separation agreements entered into after December 31, 2018, the deduction for alimony or separate maintenance payments is repealed. Recipients of alimony or separate maintenance payments will no longer be required to include those payments in their gross income. Existing alimony and separate maintenance agreements are grandfathered under the prior law.
- Health insurance: The shared responsibility payment for individuals failing to maintain minimum essential health insurance coverage has been reduced to $0, beginning after December 31, 2018.
- Business losses: Business losses are only permitted in the current year to the extent they do not exceed the sum of: (1) taxpayer’s gross income, and (2) $500,000 for joint filers or $250,000 for other taxpayers. Excess business losses will be disallowed and added to the taxpayer’s net operating loss carryforward.
- Net operating losses: Net operating loss deductions are limited to 80% of taxable income, and may only be carried forward to future tax years.
- “Kiddie Tax”: Children subject to the “Kiddie Tax” will have two different tax regimes for their earned and unearned income. Earned income will be taxed at the rates applied to single filers. Unearned income will be taxed at ordinary income and preferential rates applied to trusts and estates.
- Estate & gift tax: Beginning in 2018, the lifetime exemption for estate and gift taxes is increased to $11,200,000.
- Pass-through entities: Partners and shareholders of S corporations and LLCs may obtain a pass through business deduction as follows: Unless the taxpayer is below the threshold amounts described below, the deductible amount for a qualified business is the lesser of: 20% of the taxpayer’s qualified business income from the qualified business or the greater of: (i) 50% of the W-2 wages relating to the qualified business or (ii) the sum of 25% of the W-2 wages relating to the qualified business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property. For taxpayers in a service business (e.g., law, accounting, healthcare, etc.), no deduction is permitted unless taxable income is less than the threshold amounts of $157,500 ($315,000 if married filing a joint return).
TAXATION OF CORPORATIONS
- Tax rates: The corporate tax rate has been reduced to a flat rate of 21%, effective for tax years beginning on or after January 1, 2018. This includes personal service corporations.
- Alternative minimum tax: The corporate AMT has been repealed.
- Net operating losses: Net operating loss deductions are limited to 80% of taxable income, determined without regard to the deduction, for losses generated in taxable years beginning after December 31, 2017. NOLs may only be carried forward, indefinitely.
- Capital contributions: Certain capital contributions from state and local governments will no longer be excluded from income under section 118.
- Dividend received deductions: The 70% and 80% dividend received deductions for corporations have been reduced to 50% and 65%, respectively.
- Foreign taxes: A one-time repatriation tax of 15.5% for liquid assets and 8.0 percent for illiquid assets is imposed on earnings from overseas. Furthermore, a complex new system for international taxation is being implemented.
TAXATION OF PASS THROUGH ENTITIES
- Qualified business income deduction: Non-corporate taxpayers (such as partners and shareholders of S corporations and LLCs) may generally obtain a deduction equal to the lesser of 20% of qualified business income or 50% of the W-2 wages with respect to the partnership or S corporation. For taxpayers in a specified service trade or business (e.g., law, accounting, consulting, financial services), no deduction is permitted unless their taxable income is less than $157,500 ($315,000 if married filing a joint return).
- Technical terminations: The technical termination rules under section 708(b)(1)(B) are repealed for tax years beginning after 2017. No changes are made to the actual termination rules under section 708(b)(1)(A).
- Capital gains: Under general rules, gain recognized by a partnership upon disposition of a capital asset held for at least one year is characterized as long-term capital gain. Further, the sale of a partnership interest held for at least one year will generate long-term capital gain, except to the extent section 751(a) applies. Long-term capital gain will only be available with respect to “applicable partnership interests” to the extent the capital asset giving rise to the gain has been held for at least three years.
- Built-in gains tax: The built-in gains tax will apply at the corporate tax rate of 21%, effective for tax years beginning after January 1, 2018.
BUSINESS EXPENSES AND DEDUCTIONS
- Section 199 deductions: The new law repeals the deduction for qualified domestic production activities previously allowed under Section 199 of the tax code. This applies for corporations and owners of pass-through entities.
- Interest deductions: For most taxpayers, the limitation on net interest expense deduction will be 30% of adjusted taxable income. The business interest deduction is limited to the sum of (1) business interest income, (2) 30% of the taxpayer’s adjusted taxable income, and (3) the floor plan financing interest of the taxpayer for the taxable year. Disallowed interest will have an indefinite carryforward period. Small businesses with less than $25 million in annual gross receipts over a three-year period are exempted from the interest limitation.
- Like-kind exchanges: Like-kind exchanges under section 1031 will be limited to real property that is not held primarily for sale. The like-kind exchange rules will no longer apply to any other property, including personal property that is associated with real property. This provision generally applies to exchanges completed after December 31, 2017. However, if a taxpayer has started a forward or reverse deferred exchange prior to December 31, 2017, section 1031 may still be applied to the transaction.
- Entertainment expenses: The deduction for business-related entertainment is repealed. No deduction is allowed for entertainment, or recreation activities, facilities, or membership dues related to such activities.
- Meals expenses: Entertainment meals are non-deductible. Taxpayers can still generally deduct 50% of the cost of qualified meals associated with operating a trade or business. Meals incurred on business travel are 50% deductible. Deduction for meals provided on or near employee’s premises (considered to meet requirements for de minimis fringes) for convenience of the employer reduced from 100% to 50% for amounts paid or incurred after December 31, 2017, and until December 31, 2025. Such amounts incurred and paid after December 31, 2025, will not be deductible.
COST RECOVERY PROVISIONS
- Bonus depreciation: Property defined under section 168(k) and placed in service after September 27, 2017, and before January 1, 2023, is allowed a 100% deduction for the taxable year in which the property is placed in service. The 100% allowance is phased down by 20% per year for property placed in service after January 1, 2023 (80% for 2023; 60% for 2024; 40% for 2025; and 20% for 2026). Property eligible for bonus depreciation has been expanded to include used property.
- Luxury car rules: Annual depreciation limitations for luxury automobiles under section 280F have been increased to $10,000 in the first year, $16,000 in the second year, $9,600 in the third year, and $5,740 in the fourth and later years. The new limitations apply for automobiles placed in service after the 2017 tax year.
- Listed property: Computer or peripheral equipment is removed from the definition of listed property and no longer subject to the heightened substantiation requirements currently required.
- Section 179 deduction: Under section 179, business taxpayers may elect to deduct the cost of qualifying property with an annual limit of $1 million for tax years beginning in 2018 (2017 limit is $510,000). The $1 million limitation is reduced by the amount of which the cost of the property placed in service during the taxable year exceeds $2.5 million (2017 phase-out starts at $2,030,000). These amounts will be indexed for inflation after 2018. The section 179 definition of qualified real property is expanded to include improvements to nonresidential real property including roofs, heating, ventilation, air conditioning, fire protection, alarm systems, and security systems.
- Qualified improvement property: The definition of qualified improvement property eliminates the separate definitions for “qualified leasehold improvement,” “qualified restaurant property” and “qualified retail improvement property.” The 15-year recovery period remains unchanged.
TAX ACCOUNTING METHOD PROVISIONS
- Cash method: Under section 448, C corporations, a partnership with a C corporation partner, or a tax shelter generally may not use the cash method of accounting. One exception is for C corporations or partnerships with a C corporation partner with average annual gross receipts of not more than $25 million over the prior three years. This threshold was increased from $5 million under prior law.
- UNICAP: Taxpayers subject to UNICAP provisions under section 263A are required to capitalize all direct costs and an allocable portion of most indirect costs that are associated with production or resale activities. Businesses which meet the $25 million average annual gross receipts test would be exempt from the UNICAP requirements under section 263A.
- Inventory reporting: Businesses that meet the $25 million average annual gross receipts test would be exempt from inventory reporting under section 471. Taxpayers would be permitted to use a method of accounting that either treats inventories as non-incidental materials and supplies or conforms to the taxpayer’s financial accounting.
- Farming C corporations: Farms that meet the $25 million average three-year gross receipts threshold are permitted to use the cash method of accounting, even if it is a corporation or partnership with a corporate partner that would normally be required to use the accrual method under section 447.
- Construction reporting: Construction contracts that are expected to be completed within a two-year period and have annual average gross receipts over the preceding three years of $25 million or less are no longer required to use percentage of completion accounting for long term contracts under section 460.
- Income recognition: An accrual basis taxpayer is now required to recognize an item into income no later than the year in which the item is taken into account on the applicable financial statement. Thus, an accrual method taxpayer with an applicable financial statement would include an item in income under section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an applicable financial statement. An exception will apply for any item of income using a special method of accounting.
- Research expenditures: Taxpayers may elect to currently deduct the amount of certain reasonable research or experimental expenditures paid or incurred in connection with a trade or business under section 174, or elect to capitalize and amortize such expenditures over not less than 60 months. Alternatively, a taxpayer may elect to amortize research or experimental expenditures over ten years. Under the new legislation, specified research or experimental expenditures, including software development, would be required to be capitalized and amortized over a five-year period (15 years if expenditures are attributable to research conducted outside of the United States) and no longer currently deductible. Land acquisition and improvement costs, and mine (including oil and gas) exploration costs would be exempt from this rule. Upon retirement, abandonment or disposition of the property, any remaining basis would continue to be amortized over the remaining amortization period. The provision will apply for expenditures paid or incurred in tax years beginning after December 31, 2022.
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