On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act of 2017 (the “Bill”) into law, signifying the most drastic federal tax reform since 1986. The Bill significantly reduces the federal corporate tax rate from its highest marginal rate of 35 percent to 21 percent and made other notable changes to pass-thru income, personal income taxes, and the estate tax. This summary is a high-level overview of some of the Bill’s most significant considerations but does not address the Bill in its entirety.
Entity Structure and the Bill: New Options, New Opportunities
- Taxation for a Corporation. The corporate tax rate is reduced to 21 percent; however, before choosing such a structure, taxpayers should consider whether the reduced corporate income tax rate will yield tax savings because dividend distributions from a corporation are still subject to a second income tax. Ultimate tax savings under such a regime is highly dependent on the taxpayer’s income tax bracket and, for high earners, may not provide sufficient savings.
- Taxation for an S Corporation, Partnership or Sole Proprietorship (“Pass-Thru Entities” or “PTE”). The reduction in tax rates provided to corporations was not extended to PTEs; however, the Bill does provide a benefit to PTEs. Subject to certain limitations and requirements, the Bill allows an owner of a PTE to a deduction of 20% (“QBI Deduction”) of a taxpayer’s combined Qualified Business Income (“QBI”). This means that no tax will be paid on 20% of PTE income. The limitations and requirements can reduce the benefit of the QBI Deduction; what follows are the primary limitations and requirements:
Type of Business: If the PTE is a provider of professional services (e.g., accountant, physician, financial adviser or attorney), taxpayers with taxable income in excess of $415,000 for married filing jointly ($207,500 for married filing separately or single) are not entitled to the QBI Deduction. Additionally, the QBI Deduction decreases from $315,000 to $415,000 (typically referred to as a “phase out”).
For PTEs that do not provide professional services, the phase-out does not apply; however, a different calculation is used. The QBI Deduction equals the lesser of (a) 20% of their QBI; or (b) the greater of: (i) 50% of the PTE’s W-2 wages paid to employees or (ii) 25% of the PTE’s W-2 wages paid to employees plus 2.5% of the taxpayer’s unadjusted basis of assets (e.g., the real estate held in a partnership).
Consider the following examples:
EXAMPLE 1: Gary is the sole owner of Startup, LLC (the “LLC”), which manufacturers widgets. The LLC generated total ordinary income of $150,000. The LLC does not have any employees. Gary has no other sources of income other than from the LLC. Gary’s QBI deduction is equal to $30,000 ($150,000 x 20%).
EXAMPLE 2: Jim owns 30% of Widgets, LLC (the “LLC”). The LLC generated total ordinary income of $10,000,000 and paid total W-2 wages of $1,000,000. The total adjusted basis of property held by Widgets, LLC is $50,000,000. Jim is allocated 30% of all entity-level items. To calculate Jim’s QBI Deduction, three calculations must be completed:
- 20% of QBI: $600,000 (20% x ($10,000,000 x 30%))
B.1. 50% of W-2 Wages Paid: $150,000 (50% x ($1,000,000 x 30%))
B.2. 25% of W-2 Wages Paid Plus 2.5% of unadjusted basis: $450,000 ((25% x ($1,000,000 x 30%)) + (2.5% x ($50,000,000 x 30%))
The QBI Deduction is the lesser of A or the greater of B.1. or B.2.; therefore, Jim’s QBI Deduction equals $450,000.
EXAMPLE 3: Sheila is the sole owner of Physicians, LLC (the “LLC”), which provides physician services performed by Sheila. The LLC paid Sheila a reasonable salary of $100,000 and distributions of $130,000. Sheila files married filing jointly and the joint tax return reports taxable income for the year of $310,000. Sheila’s QBI Deduction is $66,000 (20% x $330,000).
- Bonus Depreciation – Section 179. Bonus Depreciation allows accelerated deductions for a property, to be 100% of the purchase price for property purchased between 9/27/17 and 12/31/2022. From 2022 through 2026, bonus depreciation will be reduced annually. Modifications were also made to the deduction of leasehold improvements.
- Carried Interest. Carried Interest rules were modified to require a holding period of 3 years for capital gains treatment. This is unlikely to impact the general partners in long-term real estate development but may impact the investment management industry.
Personal Income Tax Modifications
- Tax Brackets. The existing seven marginal income tax brackets were each reduced by 3%, on average, resulting in a maximum rate of 37.9%. A chart comparing the old and new brackets is included at the end of this Client Alert.
- Personal Exemptions. The Personal Exemptions are eliminated.
- Child Care Credit. The child care credit is doubled to $2,000 with the phase-outs significantly increased.
- 529 Plans. Section 529 College Savings Plans were extended to allow funds (up to a maximum of $10,000 per year) to be used for private school education for grades K through 12.
- Standard Deductions. The Standard Deduction for married filing jointly doubles.
- State Tax Deductions. State Income and Property Tax deductions for taxpayers who itemize were capped at $10,000.
- Charitable Contributions. Charitable Contribution Deductions were increased from 50% of adjusted gross income (“AGI”) to 60% of AGI. Carryover Charitable Contribution Deductions from previous years remain subject to the 50%.
- Alimony. Alimony is no longer deductible for spouses that pay alimony subject to a separation agreement entered after 12/31/2017.
Federal Estate & Gift Taxes
The estate and gift tax was not repealed by the Bill. However, the exemption, which represents the amount of wealth that may be transferred tax-free during a taxpayer’s lifetime, increased to $11.1 million per taxpayer ($22.2 million for a married couple), representing a doubling of the existing exemption. The new exemptions significantly reduce the need to undertake a gifting strategy unless an estate exceeds $11.1 million ($22.2 million for couples). The increased exemption scheduled sunsets in 2028. Taxpayers should monitor any changes to determine whether gifting should be undertaken before the sunset. Basis step up upon death remains the law and should continue to be considered when balancing including property in an estate compared to the tax savings of the step-up basis, particularly considering that the exemption is so high.
2017 Federal Tax Rates and Marginal Tax Brackets
|Tax Rate||Single||Married Filing Jointly||Married Filing Separate||Head of Household|
|10%||$0 – $9,325||$0 – $18,650||$0–$9,325||$0-$13,350|
|15%||$9,326 – $37,950||$18,651 – $75,900||$9,376–$37,950||$13,351-$50,800|
|25%||$37,951 – $91,900||$75,901 – $153,100||$37,951-$76,550||$50,801-$131,200|
|28%||$91,901 – $191,650||$153,101 – $233,350||$76,551-$116,675||$131,201-$212,500|
|33%||$190,651-$416,700||$233,351 – $416,700||$116,676-$208,350||$212,501-$416,700|
|35%||$416,701-$418,400||$416,701 – $470,700||$208,351-$235,350||$416,701-$444,550|
|39.6%||over $418,400||over $470,700||over $235,350||over $444,550|
2018 Income Tax Brackets and Rates Under the Tax Cuts and Jobs Act of 2017
|10%||Up to $9,525||Up to $19,050||Up to $9,525||Up to $13,600|
|12%||$9,526 to $38,700||$19,051 to $77,400||$9,526 to $38,700||$13,601 to $51,800|
|22%||$38,701 to $82,500||$77,401 to $165,000||$38,701 to $$82,500||$51,801 to $82,500|
|24%||$82,501 to $157,500||$165,001 to $315,000||$82,501 to $157,500||$82,501 to $157,500|
|32%||$157,501 to $200,000||$315,001 to $400,000||$157,501 to $200,000||$157,501 to $200,000|
|35%||$200,001 to $500,000||$400,001 to $600,000||$200,001 to $300,000||$200,001 to $500,000|