On November 2nd, following months of buzz but few details, the House of Representatives introduced the “Tax Cuts and Jobs Act”, the opening salvo in what is sure to be a contentious process of turning complex legislation into law before Congress’s self-imposed year-end deadline.
Summary of the Bill
Billed as a sweeping overhaul of the United States tax system, it reduces the current 7-federal tax brackets of 10%, 15%, 25%, 28%, 35% and 39.6%, and moves to a 4-bracket system with rates of 12%, 25%, 35% and 39.6%. The Bill increases the income thresholds subject to the top rate from $480,051 to $1,000,000 for married couples filing a joint return, and from $426,701 to $500,000 for individuals. High earners, defined as those with adjusted gross income in excess of $1,200,00 for married couples filing a joint return, and $1,000,000 for individuals, will see the phase-out of the 12% bracket and a 6% surtax on excess earnings above the threshold. This effectively creates an additional bracket of 45.6% for earnings between $1,200,000 to $1,614,000 for married filers and $1,000,000 to $1,207,000 for singles. At this point, any earnings that were subject to the 12% rate (the first $90,000 for married filers, and the first $45,00 for singles) have been taxed at the top rate of 39.6% and any additional earnings are not subject to the 6% surcharge. Following is a comparison of the current 2018 rates and those proposed in the GOP bill.
2018 Rates (current law): Married Filing Joint Returns and Surviving Spouses
|If Taxable Income is Between:||Tax Due is:|
|0-$19,050||10% of taxable income|
|$19,051-$77,400||$1,905 plus 15% of the amount over $19,050|
|$77,401-$156,150||$10,657.50 plus 25% of the amount over $77,400|
|$156,151-$237,950||$30,345 plus 28% of the amount over $156,150|
|$237,951-$424,950||$53,249 plus 33% of the amount over $237,950|
|$424,951-$480,050||$114,959 plus 35% of the amount over $424,950|
|$480,051 and above||$134,244 plus $39.6% of the amount over $480,050|
Proposed Rates: Married Filing Joint Returns and Surviving Spouses
|If Taxable Income is Between:||Tax Due is:|
|0-$90,000||12% of taxable income|
|$90,001-$260,000||$10,800 plus 25% of the amount over $90,000|
|$260,001-$1,000,000||$53,300 plus 35% of the amount over $260,000|
|$1,000,001-$1,200,000||$312,300 plus 39.6% of the amount over $1,000,000
|$1,200,001-$1,614,000||$391,500 plus 45.6% of the amount over $1,200,000|
|$1,614,001 and above||$580,284 plus 39.6% of the amount over $1,614,000|
An Increase in The Standard Deduction
Another much-touted feature of the legislation is the increase in the existing standard deduction. The Act increases the 2018 standard deduction to $12,200 for individuals and $24,400 for married couples filing a joint return- up from $6,500 for individuals and $13,000 for couples under current law. To offset the increase, the proposed legislation eliminates the personal exemption amount of $4,150 per individual. The net result is an increase of $1,550 over the existing combination of the standard deduction and personal exemption for an individual, and a $3,100 increase for couples filing a joint return. For those with dependent children under age 17, the proposed legislation increases the Child Tax Credit from $1,000 per child to $1,600 per child and adds a $300 credit for each non-child dependent or parent for a period of five years. This increase in the standard deduction and the proposed limitations to itemized deductions is expected to result in a sharp decline in the number of taxpayers that will benefit from itemizing their deductions.
The Impact on Itemized Deductions
The ability to itemize deductions remains in the new legislation, but sharply curtails the benefits of itemizing. In an effort to simplify the tax code, the GOP legislation seeks to limit or eliminate entirely many popular deductions.
- Elimination of the deduction for state and local income taxes paid.
- Limiting the deduction for real estate taxes paid to $10,00 per year.
- Elimination of the medical expense deduction.
- Limiting the deduction of casualty losses (personal losses resulting from events such as fire, storm, theft, or the like) to those events specifically authorized by Congress.
- Elimination of employee business expenses, including the deduction for a home office, or for expenses not reimbursed through an employer. Tax preparation and certain legal fees formerly deductible would also be eliminated.
- Limiting the interest deduction to $500,000 of acquisition debt on a primary residence, down from $1,000,000 of acquisition debt, and not limited to a primary residence under current law.
Though not itemized, several popular deductions or credits, including those for educator expenses, health savings accounts, moving expenses and student loan interest will be impacted by the legislation. Adoption tax credits and electric motor vehicle credits are also on the chopping block, so be sure to rush out and buy your shiny new Tesla before year end.
A Repeal of the Alternative Minimum Tax
While Republican and Democrats agree on very little, the legislation’s proposed repeal of the alternative minimum tax (AMT) may provide a rare bipartisan Kumbaya moment. Those impacted by the AMT can rejoice, but it’s worth noting that many of the tax preference items used in the AMT calculation were also curtailed or eliminated for regular income tax reporting.
Important Changes to Capital Gains
Capital gains and (qualified) dividends would retain their current three-bracket structure, with those in the bottom two brackets (10% and 15%) being eligible for a 0% capital gains tax rate, taxpayers in the middle four tax brackets (25%, 28%, 33% and 35%) taxed at a 15% capital gains tax rate, and those in the top bracket paying a 20% rate on long-term capital gains and qualified dividends. And the 3.8% Medicare surtax remains in effect. Perhaps an oversight, the GOP bill leaves the capital gains rates under current law in effect but does not adjust them to match the proposed 4-income tax brackets. We trust that someone other than us will pick up on this and make a correction as the bill moves through committee.
Also worth noting is that the exclusion on capital gains from the sale of a primary residence remains at $250,000 per individual or $500,000 per couple under the proposed legislation, but the Act limits the deduction’s use to once in a five-year period, introduces an income-based phase out of the exclusion, and increases the amount of time that you must reside in the home and use it as your personal residence from 2 of the last 5 years to 5 of the past 8 years. In practice, this means you must reside in your primary residence for 5 years and meet the income thresholds to be eligible for the capital gains exclusion.
Corporate Tax Cuts
Headline-grabbing cuts to corporate taxes are included in the bill, with a reduction in the headline rate from 35% under current law to 20% under the GOP proposal. Under the proposal, rates would be reduced in exchange for the elimination of most business deductions and credits, with the exception of those for research and development and low-income housing. The proposed legislation also creates a new 25% tax rate for “pass-through” businesses such as sole proprietorships, partnerships and S corporations that are currently subject to the owner’s individual tax rates. Note, however, that limitations would apply to professional service providers such as physicians, accountant, attorneys and financial advisers. Along with these changes, the GOP bill also seeks to streamline business tax reporting by eliminating many employee fringe benefits that are now fully or partially deductible. Some examples include moving expense reimbursement, employer-provided child care credit, adoption assistance programs, meals and entertainment expenses and employer-provided educational assistance. One of the most talked about provisions is a reduction in contributions to 401K plans. Though there is no mention of this in the House bill, it could reappear in subsequent versions.
Gift and Estate Tax Exemptions Increase with Eventual Estate Tax Repeal
A final provision worth noting is the proposed increase in the 2018 estate and gift tax exemption amounts from the projected $5,600,000 to $11,200,000. These amounts would be doubled for married couples, resulting in a $22,400,000 exemption. The GOP bill would repeal the estate tax entirely beginning in 2024 but would leave the gift tax in place. The gift tax exemption would be adjusted for inflation each year, as would the annual gift exclusion, and the gift tax rate would be reduced from 40% to 35% in 2024. Interestingly, and despite the repeal of the estate tax, a step-up in cost basis at death remains in the GOP bill, effectively eliminating unrealized capital gains that accrued prior to death.
Legislative Priorities: Business versus Personal Interests
Any piece of complex legislation will benefit certain groups at the expense of others. One clear winner in the GOP’s tax proposal is business interests. An estimated 60% of the benefits of the tax cuts will accrue to corporations, with an additional 20% reserved for pass-through businesses. The remaining 20% will be passed on to individual taxpayers.
Individuals that do not itemize deductions may see a decrease in their taxable income as a result of the increased standard deduction. The compression of the tax brackets will also push many taxpayers into a lower marginal tax bracket and may help offset some of the deductions or credits that are reduced or eliminated. Also celebrating will be private-equity managers, venture capitalists, hedge fund managers and some real estate investors, as the bill leaves intact the carried interest preference. In addition, those subject to the estate tax will reap an enormous benefit based on the combination of increasing the gift and estate tax exemption amounts and retaining the step-up in basis. And, of course, after 2024 the estate tax would be repealed entirely.
Among the losers are those that reside in high-tax states that are currently able to deduct state and local taxes and property taxes in their entirety, those with large mortgage acquisition debt, and those with large medical bills or casualty losses. Larger families that would benefit from the personal and dependent exemptions may also lose out, though this may be mitigated by an increase in the Child Tax Credit.
Finally, it is worth noting that, according to the Congressional Budget Office, the House bill’s projected fiscal impact is an estimated $1.7 trillion dollar revenue loss over ten years, which is well above the $1.5 trillion ceiling set under the budget reconciliation threshold. Under the budget rules that Senate Republicans will rely on to pass the Act with a simple majority vote, an increase in the budget deficit is limited to $1.5 trillion over 10 years. Republicans are currently looking for ways to raise revenue to reduce the fiscal impact. This suggests not only that the bill will be modified in the coming days and weeks, but also that large revenue raisers such as scrapping the deduction for state and local income taxes stand a good chance of remaining in the final version.
Whether the bill becomes law is far from certain, as the recent history of proposed legislation suggests. Still, this bill provides a useful glimpse into the legislative priorities of the GOP, along with some hitherto lacking detail. What is clear is that smart tax planning remains as relevant as ever.
John Male, CFP®, RICP®
The Gassman Financial Group
The Retirement Maven™
9 East 40th Street
New York, NY 10016