The Tax Cuts and Jobs Act was signed into law on December 22, 2017 (the “Act”) and made significant changes to income tax laws affecting businesses and individuals. This article describes some of the changes that may be of greatest impact to businesses and individuals. Most individual taxpayers are expected to see a reduced tax bill, but it is possible that some taxpayers (likely those with more complex tax returns) could experience bigger income tax bills due to the elimination or restriction on certain itemized deductions. Businesses are also expected to see an overall benefit from the Act due to the fact that the overall tax rate is decreased and permitted expense and depreciation deductions are expanded, even though the business interest expense deduction is limited for larger corporations.
Tidbits for Individuals
Tidbit #1: Elimination of Personal Exemption and Increase in Standard Deducation
The Act eliminates the personal exemption which generally allowed taxpayers to reduce his or her taxable income by $4,050 and could also be claimed for a spouse or any dependent. However, the Act increased the standard deduction amounts to $12,000 for single filers and $24,000 for joint filers.
Tidbit #2: Limits on Itemized Deductions
The Act eliminated or put substantial limitations on a number of itemized deductions, including the following, which will affect many individual taxpayers:
State and Local Taxes (“SALT”)
The Act capped annual itemized deductions for all state and local taxes, including property taxes, at $10,000. This provision will significantly impact taxpayers in high income tax states such as California, New York, Massachusetts, Illinois, Iowa and even Minnesota because they won’t be able to deduct state and local taxes paid on their federal income tax returns.
Mortgage and Home Equity Loan Interest Deduction
The itemized deduction for home mortgage interest is limited to interest paid or accrued on acquisition debt, and the deduction for interest on home equity debt is suspended unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan (so no deduction if your home equity loan used to pay living expenses). Beginning in 2018, the maximum amount that may be treated as acquisition debt is also reduced to $750,000 ($375,000 if married filing separately) which is down from the prior limit of $1,000,000 ($500,000 if married filing separate).
Miscellaneous itemized deductions subject to the 2 percent floor, including unreimbursed employee business expenses (uniforms, union dues, and business-related meals), tax preparation fees and investment advisory fees, are suspended. Additionally, the deduction for moving expenses including mileage is suspended (this suspension does not apply to service members relocating pursuant to a military order).
Medical Expense Deduction
The threshold for medical expense deductions is lowered to 7.5 percent of adjusted gross income (AGI) for tax years 2017 and 2018, and casualty losses will only be allowed for losses in federally declared disaster areas.
With the restrictions on itemized deductions, a large number of taxpayers will no longer have itemized deductions that exceed the standard deduction. However, with the increase in the amount of the standard deduction, most taxpayers should see an overall decrease in taxable income.
The supporters of the Act also note that an enhanced child and family tax credit will make up some of the difference for certain families caused by the reduced number of itemizations. The child tax credit under the Act may be as high as $2,000 depending on income and the phase-out limit on adjusted gross income was increased to $400,000 for a married couple filing jointly. As a credit, in contrast to a deduction, the enhanced child credit has been highlighted as one of the provisions that will lower overall tax liability for many middle-class families.
Notably, the Act also enhanced the deduction for charitable contributions by raising the limit that can be contributed in any one year. The limit is now 60% of adjusted gross income, up from 50%. However, taking a charitable deduction (along with all other itemized deductions) will only decrease your tax liability if your total itemized deductions (SALT, mortgage interest, medical expenses, etc.) exceed the increased standard deduction amount.
Tidbits for Businesses
Tidbit #1: Lower Tax Rate But Less Business Interest Expense Deduction
One of the most significant provisions of the Act is the reduction of the corporate tax rate from 35% to 21%. In order to partially offset the tax rate cut, the Act places new limitation on the amount of business interest that can be deducted. Generally, business interest is the cost of interest on loans used to maintain business operations. For most large businesses, the deduction is now limited to 30% of the business’ adjusted taxable income. However, this provision does not apply to large businesses engaged in a “real property trade or business.”
The limitation also does not apply to small businesses, farms, and certain utilities. A “small business” is defined as a company with average annual gross receipts of $25 million or less over a trailing three-year period. The three-year lookback ensures that businesses cannot be broken up to come in under the $25 million threshold.
Tidbit #2: More Depreciation and Expensing
Generally, business taxpayers can depreciate tangible personal property (not land), including buildings, machinery, vehicles, furniture and equipment.
The new Act provides the following changes to expense and depreciation rules:
- The maximum expense deduction increased from $500,000 to $1,000,000; therefore, businesses can immediately expense more under the new Act and taxpayers may elect to expense the cost of any Section 179 property and deduct it in the year the property is placed in service. The annual phase-out threshold also increased from $2 million to $2.5 million (the taxpayer cannot have purchased more than this amount during the year).
- The bonus depreciation percentage is increased from 50% to 100% for qualified property acquired and placed in service after September 28, 2017 and before January 1, 2023. The definition of qualified property was also expanded to include USED qualified property so long as the taxpayer didn’t use it prior to acquiring it, and did not acquire it from a related party or component member of the business. This will increase the applicability of the provision and could be very beneficial for certain industries.
- The Act consolidated definitions that address when certain improvements to nonresidential real property can be depreciated. Previously, different rules applied to certain categories of leasehold improvements and qualified improvement property. The Act eliminated references to leasehold improvements and left only the category of qualified improvement property. It appears the intent of the Act is to permit a 15 year regular depreciation life for those improvements to nonresidential property that meet the definition of qualified improvement property (generally meaning any improvement to a building’s interior, but not if they are attributable to the enlargement of the building, any elevator or escalator or the internal structural framework of the building).
NOTE: Certain technical corrections to the Act will be required to properly implement the new expensing and depreciation provisions.
Tidbit #3: Pass-Through Business Income Deduction
The Act creates a new tax deduction of up to 20% of income from partnerships, sole proprietorships, and other pass-through businesses. However, the amount of the deduction will vary based on the type of business and the total income earned by the business owner(s). For example, certain limitations apply to “personal service” businesses such as law firms, medical firms and consulting firms. However, regardless of business type, if a qualifying business owner makes less than $157,000 (single-filers) or $315,000 (joint-filers) in total taxable income, the business owner may take the full 20% deduction. For taxpayers with income above those limits, the deduction begins to phase out and for earners over $207,000 (for single-filers) and $415,000 (joint-filers), the deduction is eliminated for “personal service” businesses and reduced for other pass-through businesses.
Tidbit #4: Blended Tax Return
For federal income tax reporting purposes, many businesses use a fiscal year end and not a calendar year. Pursuant to the Act, a business with a fiscal year that includes January 1, 2018 will pay federal income tax using a blended tax rate and not the flat 21% tax rate that would generally apply to taxable years beginning after December 31, 2107.
The Act provided a major overhaul of the tax code and the above highlights only a small portion of the many significant changes under the Act. It will be very important to work closely with tax professionals throughout 2018 to ensure appropriate steps are taken in light of the changes under the Act.
Mia E. Thibodeau is an attorney with Fryberger, Buchanan, Smith & Frederick, P.A., and practices in the areas of family law, estate planning, real estate and municipal law.