The Tax Cuts and Jobs Act makes major changes to individual income taxation. These include a reduction in the number of tax brackets, an increase in the standard deduction, repeal of personal exemptions, a reduced maximum rate on business income, an increase in the child tax credit and a new family tax credit, repeal of the credits for the elderly and for adoption expenses, changes to education incentives and to many deductions, including a new limit on mortgage interest, repeal of the personal casualty loss, state income and sales tax, medical expense, moving expense, tax preparation expense, and employee business expense deductions, and a dollar limit on property tax deductions.
The home sale exclusion would be tightened and phased out at higher income levels. There would be many changes to retirement plan rules. The AMT would be repealed, and the basic estate tax exclusion would be doubled and the tax repealed after 2023, with beneficiaries still getting a stepped-up basis in estate property. The Act also contains extensive changes to corporate and business taxes, foreign income and persons, and exempt organizations. The House Ways and Means Committee is marking up the bill this week and still introducing amendments and modifications. This article is based on the bill introduced last week.
Changes to Tax Rates and Brackets
New brackets and break points: The Act would reduce the number of tax brackets (ranging from 10 percent to 39.6 percent) from seven to four: 12 percent, 25 percent, 35 percent, and 39.6 percent.
The framework had provided for a top rate of 35 percent, but left open the possibility that “[a]n additional top rate may apply to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code.”
The 25 percent bracket would begin at $90,000 for joint returns/surviving spouses, $67,500 for heads of household, half of the joint amount for any other individuals (i.e., $45,000), and $2,550 for an estate or trust. (Income under this amount would be subject to the 12 percent rate.)
The 35 percent bracket would begin at $260,000 for joint returns/surviving spouses, half of the joint amount for a married individual filing separately (i.e., $130,000), $200,000 for any other individuals, and $9,150 for an estate or trust.
The 39.6 percent bracket would begin at $1 million for joint returns/surviving spouses, half of the joint amount for any other individual (i.e., $500,000), and $12,500 for an estate or trust.
In addition, the Act would provide for a phase-out of the 12 percent rate under which, as described in the Section-by-Section summary, the benefit of the 12 percent rate is phased out for taxpayers with AGI over $1 million ($1.2 million for joint filers).
Inflation adjustment: For tax years beginning after 2018, the dollar amounts above would be indexed for inflation. And, beginning in 2023, the measure of inflation would be chained CPI (Consumer Price Index), as opposed to CPI-U (CPI for all urban customers) under current law.
In general, chained CPI grows at a slower pace than standard CPI because it takes into account a consumer’s ability to substitute between goods in response to changes in relative prices. Proponents for the use of chained CPI say that the traditional CPI overstates increases in the cost of living because it doesn’t take into account the fact that consumers generally adjust their buying patterns when prices go up, rather than simply buying an item at a higher price.
Capital gains: Under the Act, a 0 percent capital gains bracket would apply to capital gains “below the 15 percent rate threshold” ($77,200 for a joint return or surviving spouse, $51,700 for a head of household, half of the joint amount for other individuals, and $2,600 for estates and trusts). A 15 percent bracket would apply to gains below the 20 percent rate threshold ($479,000 for joint return or surviving spouse, half the joint amount for a married individual filing separately, $425,800 for any other individual, and $12,700 for an estate or trust). (Act Sec. 1001(b))
These thresholds would be adjusted for inflation after 2018. Presumably, the 20 percent bracket remains in effect for capital gains in excess of these thresholds.
Effective date: The above changes would be effective for tax years beginning after Dec. 31, 2017.
Increased Standard Deduction and Elimination of Personal Exemptions
Standard deduction increased: The Act would increase the standard deduction to $24,400 for joint returns and surviving spouses, three-quarters of the joint amount for unmarried individuals with at least one qualifying child (i.e., $18,300), and half of the joint amount in any other case (i.e., $12,200).
According to the section-by-section summary, this increase would significantly reduce the number of taxpayers who choose to itemize their deductions.
The section-by-section summary and other releases on the bill indicate that the standard deduction would be $24,000 for joint filers and $12,000 for individuals.
For individuals who are claimed as dependents, the Act would limit the standard deduction to the greater of $500 or the sum of $250 and the individual’s earned income.
Personal exemptions repealed: The Act would repeal the deduction for personal exemptions (under current law, for 2018, $4,150, subject to a phase out for higher earners), as well as the personal exemption phase out.
Effective date: The new standard deductions and repeal of personal exemptions would go into effect for tax years beginning after Dec. 31, 2017.
New Maximum Rate on Business Income of Individuals
25 percent “business income” rate: The Act would provide a new maximum rate of 25 percent on the “business income” of individuals. The bill sets out a formula under which it reduces the tax that would otherwise apply to “qualified business income” in order to achieve this maximum rate.
“Qualified business income” is generally defined as the excess (if any) of (i) the sum of 100 percent of any net business income derived from any passive business activity plus the capital percentage of any net business income derived from any active business activity, over (ii) the sum of 100 percent of any net business loss derived from any passive business activity, 30 percent of any net business loss derived from any active business activity, plus any carryover business loss for the preceding tax year.
Capitol building in Washington, D.C.
As explained in the section-by-section summary, owners or shareholders could elect to apply a “capital percentage” (defined as 30 percent) to the net business income derived from active business activities to determine their business income eligible for the 25 percent rate (with the remaining 70 percent subject to ordinary individual income tax rates), or they may elect to apply a formula based on the facts and circumstances of their business to determine an amount greater than the 30 percent capital percentage. The percentage may be increased for certain “capital-intensive business activities.” However, the percentage is zero for certain personal services business—e.g., law, accounting—and taxpayers actively participating in those business wouldn’t be eligible for the 25 percent business income rate.
Anti-abuse rule: The section-by-section summary explained that special rule would apply to prevent the recharacterization of actual wages paid as business income. An owner’s or shareholder’s capital percentage would be limited if actual wages or income treated as received in exchange for services from the pass-through entity (e.g., a guaranteed payment) exceeds the taxpayer’s otherwise applicable capital percentage.
New 25 percent rate for certain dividends of REITs and cooperatives: The Act would also provide that certain dividends of real estate investment trusts and patronage dividends from cooperatives are subject to a 25 percent rate. (Act Sec. 1004(b) Dividends that meet certain requirements would increase net capital gain and unrecaptured section 1250 gain under Code Sec. 1(h)(11) and Code Sec. 1(h)(6), respectively (both of which set out a 25 percent rate).
Effective date: The above provisions would go into effect for tax years beginning after Dec. 31, 2017, subject to a transition rule.
Enhanced Child Tax Credit and New Family Tax Credit
Increased child tax credit: The Act would increase the amount of the child tax credit under Code Sec. 24 from $1,000 to $1,600. It would also replace the term “qualifying child” with “dependent” and eliminate the phrase “for which a the taxpayer is allowed a deduction under section 151.” Alternatively, the act would provide a $300 credit for non-child dependents.
In addition, the Act would provide for a “family flexibility credit” that would be allowed with respect to the taxpayer (each spouse in the case of a joint return) who is neither a child nor a non-child dependent. Both the family flexibility credit and the non-child dependent credit would be effective for tax years ending before Jan. 1, 2023.
Phase-out: The Act would also increase the income levels at which the credit phases out. Under current law, the credit is phased out beginning at income levels of $75,000 for single filers and $110,000 for joint filers. The Act would raise these amounts to $115,000 and $230,000, respectively.
Refundable portion: Under current law, the child tax credit is partially refundable. The Act would limit the amount that is refundable to $1,000, and index this amount to inflation based on chained CPI (up to a maximum amount of the $1,600 base credit). A taxpayer would be required to provide a Social Security number (SSN) to claim the refundable portion of the credit.
Effective date: These amendments would apply to tax years beginning after Dec. 31, 2017.
Repeal of Certain Nonrefundable Credits
Repealed credits: The Act would repeal:
• The credit for individuals over age 65 or who have retired on disability under Code Sec. 22;
• The adoption credit under Code Sec. 23;
• The tax credit associated with mortgage credit certificates under Code Sec. 25; and
• The credit for plug-in electric drive motor vehicles under Code Sec. 30D.
Effective date: The provision repealing qualified plug-in electric drive motor vehicles would be effective for vehicles placed in service for tax years beginning after Dec. 31, 2017. The other provisions would be effective for tax years beginning after Dec. 31, 2017.
Streamlined Education Incentives
Enhanced AOTC: The Act would consolidate three higher education credits under current law—the American Opportunity Tax Credit, the Hope Scholarship Credit, and the Lifetime Learning Credit—into an “enhanced” American Opportunity Tax Credit. The enhanced AOTC would, like the version under current law, provide a 100 percent tax credit for the first $2,000 of qualifying higher education expenses and a 25 percent credit for the next $2,000 of such expenses (for a $2,500 maximum). The HSC and LLC would be repealed.
The Act would limit the AOTC to five years of post-secondary education, with the credit for the fifth year available at half the rate as the first four years, with up to $500 being refundable.
No new Coverdell account contributions: The Act would generally prohibit new contributions to Coverdell education savings accounts after 2017.
Section 529 Account distributions: The Act would treat up to $10,000 per year for elementary and high school expenses as “qualified expenses” from Section 529 plans.
Qualified Tuition Program distributions for apprenticeships: The Act would add to the term “qualified education expenses” certain books and supplies required for registered apprenticeship programs.
Treatment of discharged student loan indebtedness: Under the Act, any income resulting from the discharge of student debt on account of death or total disability of the student would be excluded from taxable income. The Act would also exclude from income repayment of a taxpayer’s loans pursuant to the Indian Health Service Loan Repayment Program.
Other education provisions repealed: The Act would repeal:
• The above-the line deduction for interest payments on qualified education loans for qualified higher education expenses under Code Sec. 221;
• The pre-2017 above-the-line deduction for qualified tuition and related expenses under Code Sec. 222;
• The exclusion from income of interest on U.S. savings bonds used to pay qualified higher education expenses under Code Sec. 135;
• The exclusion from gross income of qualified tuition reductions provided by educational institutions under Code Sec. 117(d); and
• Employer-provided education assistance under Code Sec. 127. (Act. Sec. 1204)
Effective date. The above provisions would generally be effective after Dec. 31, 2017.
Simplification and Reform of Deductions
“Pease” limitation repealed: The Act would repeal the so-called “Pease” limitation on itemized deductions.
Mortgage interest deduction retained, but with new limits: The Act would retain the home mortgage interest deduction in its current form—i.e., subject to a $1 million cap—for mortgages that already exist on Nov. 2, 2017, as well as for taxpayers who have entered into a binding written contract before that date to purchase a home. However, for newly purchased homes, the deduction will be limited to $500,000 ($250,000 for a married individual filing separately).
The Act would also limit taxpayers to one qualified residence.
State and local property tax deduction retained, but with new limits: The Act would eliminate the deduction for state and local income or sales tax (see below), but would retain the deduction for real property taxes, subject to a $10,000 maximum.
Repealed deductions: The Act would repeal deductions for:
• Taxes not paid or accrued in a trade or business under Code Sec. 164(b)(5);
• Personal casualty losses under Code Sec. 165 (subject to an exception for disaster losses under the recent Disaster Tax Relief and Airport and Airway Extension Act of 2017);
• State and local income taxes and sales taxes;
• Tax preparation expenses under Code Sec. 212;
• Alimony payments under Code Sec. 215
• Moving expenses under Code Sec. 217;
• Medical expenses under Code Sec. 213; and
• Expenses attributable to the trade or business of being an employee under Code Sec. 262. (Act Sec. 1312)
• Contributions to Medical Savings Accounts (MSAs) under Code Sec. 220; existing balances could be rolled over on a tax-free basis into a Health Savings Account. The exclusion for employer-provided contributions to MSAs under Code Sec. 106 would also be repealed.
The Act would also modify the limitation on wagering losses under Code Sec. 165(d) to provide that all deductions for expenses incurred in carrying out wagering transactions, and not just gambling losses, would be limited to the extent of gambling winnings.
Modified rules for charitable contributions: The Act would:
• increase the 50 percent limitation under Code Sec. 170(b) for cash contributions to public charities and certain private foundations to 60 percent;
• repeal the special rule in Code Sec. 170(l) that provides a charitable deduction of 80 percent of the amount paid for the right to purchase tickets for athletic events;
• adjust the charitable mileage rate under Code Sec. 170(i) for inflation; and
• repeal the exception under Code Sec. 170(f)(8) under which a taxpayer that failed to provide a contemporaneous written acknowledgement by the donee organization for contributions of $250 or more is relieved from doing so when the donee organization files a return with the required information. (Act Sec. 1306)
Effective date: Except as otherwise noted, the above provisions would be effective for tax years beginning after Dec. 31, 2017.
Simplification and Reforms of Exclusions and Taxable Compensation
Employer-provided housing: The Act would limit the exclusion for housing provided for the convenience of the employer and for employees of educational institutions under Code Sec. 119 to $50,000 ($25,000 for a married individual filing a joint return). The exclusion would also phase out for higher-income individuals.
Gain from sale of principal residence: The Act would require that, in order to exclude gain from the sale of a principal residence under Code Sec. 121 (up to $500,000 for joint filers; $250,000 for others), a taxpayer would have to own and use as a home the residence for five out of the previous eight years (as opposed to two out of five years under current law), effective for sales and exchanges after Dec. 31, 2017. In addition, the exclusion could only be used once every five years, and it would be phased out at higher income levels.
Repealed exclusions: The Act would repeal current-law exclusions for:
• Employee achievement awards under Code Sec. 74;
• Dependent care assistance programs under Code Sec. 129;
• Qualified moving expense reimbursements under Code Sec. 132; and
• Adoption assistance programs under Code Sec. 137.
Effective date: Except as otherwise noted, the above provisions would be effective for tax years beginning after Dec. 31, 2017.
Reforms to Savings, Pensions and Retirement
Roth IRA recharacterization rule repealed: The Act would repeal the current-law provisions, in Code Sec. 408A, under which an individual may re-characterize a contribution to a traditional IRA as a contribution to a Roth IRA (and vice versa) and may also recharacterize a conversion of a traditional IRA to a Roth IRA.
Reduction in minimum age for allowable in-service distributions: The Act would permit all defined benefit plans (Code Sec. 401(a)(36), as well as State and local government defined contribution plans (Code Sec. 457(d)(1)), to make in-service distributions beginning at age 59-1/2.
Modified rules on hardship distributions: The Act would require the IRS to, within one year from the date of enactment, change its regs under Code Sec. 401(k) to allow employees taking hardship distributions to continue making contributions to the plan.
The Act would also let employers choose to allow hardship distributions to include account earnings and employer contributions.
Extended rollover period for the rollover of plan loan offset amounts in certain cases: The Act would modify Code Sec. 402(c) to provide that employees whose plan terminates or who separate from employment while they have plan loans outstanding would have until the due date for filing their tax return for that year to contribute the loan balance to an IRA in order to avoid the loan being taxed as a distribution.
Modification of nondiscrimination rules: The Act would amend Code Sec. 401 to allow expanded cross-testing between an employer’s defined benefit and defined contributions for purposes of the nondiscrimination rules, effective as of the date of enactment.
Effective date: The above provisions would be effective for tax years beginning after Dec. 31, 2017.
Estate and Generation-Skipping Transfer Taxes
Basic exclusion doubled: The Act would double the base exclusion amount under Code Sec. 2010 of $5 million (as indexed for inflation; $5.6 million for 2018 per taxpayer) to $10 million, effective for tax years beginning after Dec. 31, 2017.
Estate and GST taxes repealed after 2023: The Act would repeal the estate and GST taxes such that they do not apply to the estates of decedents dying after Dec. 31, 2023, while still maintaining a beneficiary’s stepped-up basis in estate property.
Gift tax provisions: The Act would lower the gift tax to a top rate of 35 percent for gifts made after Dec. 31, 2023, and would retain a basic exclusion amount of $10 million and an annual exclusion amount of $15,000 (for 2018), as indexed for inflation.
Alternative Minimum Tax Repeal
AMT repeal: The Act would repeal the AMT, generally effective for tax years beginning after Dec. 31, 2017.
Treatment of carryforwards: If a taxpayer has AMT credit carryforwards, the Act would allow the taxpayer to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020, and 2021, with the remainder claimed in the tax year beginning in 2022.