Early Saturday morning the US Senate passed their version of a tax-reform bill. The bill shares some similarities with, but also has stark differences from, the “Tax Cuts and Jobs Act” bill passed by the House of Representatives last month. The next step in the process will be to reconcile these differences into a final bill that both the House and Senate will need to vote on before it can be sent to the President to sign it into law.
Here is a summary of a number of key provisions of the current tax law versus both the House and Senate versions.
Changes to the individual income tax brackets:
Currently there are seven brackets as follows (based on 2017):
10% (taxable income up to $9,325 for Single; up to $18,650 for Married Filing Jointly)
15% (over $9,325 to $37,950 for Single; over $18,650 to $75,900 for MFJ)
25% (over $37,950 to $91,900 for Single; over $75,900 to $153,100 for MFJ)
28% (over $91,900 to $191,650 for Single; over $153,000 to $233,350 for MFJ)
33% (over $191,650 to $416,700 for Single; over $233,350 to $416,700 for MFJ)
35% (over $416,700 to $418,400 for Single; over $416,700 to $470,700 for MFJ)
39.6% (over $418,400 for Single; over $470,700 for MFJ)
The Senate plan:
10% (taxable income up to $9,525 for Single; up to $19,050 for MFJ)
12% (over $9,525 to $38,700 for Single; over $19,050 to $77,400 for MFJ)
22% (over $38,700 to $70,000 for Single; over $77,400 to $140,000 for MFJ)
24% (over $70,000 to $160,000 for Single; over $140,000 to $320,000 for MFJ)
32% (over $160,000 to $200,000 for Single; over $320,000 to $400,000 for MFJ)
35% (over $200,000 to $500,000 for Single; over $400,000 to $1 million for MFJ)
38.5% (over $500,000 for Single; over $1 million for MFJ)
Contrast this to the House passed bill:
0% (taxable income up to $12,000 for Single; up to $24,000 for MFJ)
12% (over $12,000 to $45,000 for Single; over $24,000 to $90,000 for MFJ)
25% (over $45,000 to $200,000 for Single; over $90,000 to $260,000 for MFJ)
35% (over $200,000 to $500,000 for Single; over $260,000 to $1,000,000 for MFJ)
39.6% (over $500,000 for Single; over $1,000,000 for MFJ)
Of particular note is a subtle change that might be missed. It is a change in the way the government will be increasing the income thresholds for these various brackets. Currently the IRS uses the Consumer Price Index (CPI). In both House and Senate versions of the bill, they will be using the Chained Consumer Price Index (C-CPI-U). Chained CPI-U results in lower estimates of inflation than the traditional CPI does.
Changes to the standard deduction and personal exemptions:
The current (2017) standard deduction is $6,350 for a Single tax filer; and $12,700 for MFJ. Both House and Senate versions dramatically increase the deduction to $12,000 for single; and $24,000 for MFJ.
The personal exemption that you’re currently able to claim (at $4,050 for you, your spouse, and each dependent) is eliminated in both House and Senate versions. This provision could actually hurt some families with three or more children – whereby reducing or even negating tax relief they might have realized otherwise.
Changes to itemized deductions:
For those that do itemize (or will still be able to going forward), there is a benefit for higher income earners. Under current law, once a taxpayer’s adjusted gross income goes over $313,800 (MFJ) or $261,500 (single), a phase out kicks in (referred to as the “Pease limitation”) where the total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds these thresholds (but not to reduce deductions by more than 80%).
The House and Senate bills repeal the Pease limitation, although the Senate version is temporary and returns in 2024. However, whereas this benefits high income earners, there are a number of changes (especially in the House bill) that may be a disadvantage to many more taxpayers who otherwise would benefit from itemizing.
For example, the House bill repeals the ability to include out-of-pocket medical expenses as a deductible item on Schedule A. Currently this deduction is allowed for expenses that exceed 10% of AGI. This could hurt elderly taxpayers who have high medical care costs. The Senate bill, thankfully, not only keeps this in, but lowers the threshold to the old 7.5% for 2017 and 2018 only, then returning to 10% in 2019 and beyond.
Another example is the controversial and hotly debated elimination of the ability to deduct state and local taxes in both the House and Senate bills (discussed later).
And yet another: Miscellaneous itemized deductions: certain items that exceed 2% of AGI are deductible (only the amount that exceeds 2%), such as tax preparation fees, unreimbursed job expenses, investment fees, union dues. The House bill would no longer allow the deductions for tax prep fees, nor unreimbursed job expenses. The Senate bill goes a step further and repeals all miscellaneous deductions in this category.
The goal of all of this is actually to simplify the tax filing process for many Americans. By eliminating many of the previously included items on Schedule A, while at the same time dramatically increasing the Standard Deduction, many taxpayers will now find that they should just take the standard deduction and not mess around with itemizing. However, I’m just not “sold on” that this will be “better” for most Americans.
Changes to the mortgage interest deduction:
Under current law, if you itemize deductions on Schedule A, you can deduct the interest you pay on a mortgage for your main home, and even a second home with some restrictions. The deduction is limited to the first $1,000,000 of all mortgages securing your main (and second) home(s). You can also deduct interest on home equity loans and lines of credit up to $100,000 of indebtedness, regardless of how you used the loan proceeds.
The House bill grandfathers existing mortgages so those taxpayers can continue to take deductions based on the current rules. However, for new mortgages the interest will be limited on mortgages up to $500,000 on principal residences only. Deductions on home equity loans would not be allowed.
The Senate bill would still allow an interest deduction on mortgage debt up to $1,000,000, however like the House bill it eliminates the deductibility of home equity loan interest.
Changes to principal residence gain exclusion on sale:
Current law allows all taxpayers, regardless of income, to exclude up to $250,000 (single); $500,000 (married filing jointly) of the gain from the sale of a principal residence – as long as the home was used as the principal residence for at least two of the five years prior to the sale. The two years do not have to be consecutive.
Both House and Senate bills make it more difficult to qualify for the exclusion requiring the homeowner to have lived in the primary residence for at least five of the last eight years. Furthermore, the House bill phases out the exclusion for those whose adjusted gross income, averaged over a three-year period, exceeds $500,000 for MFJ ($250,000 for single filers).
Changes to State and Local Tax Deduction (SALT):
Currently taxpayers that itemize deductions can deduct the state and local income taxes they pay, as well as property taxes.
Both House and (amended) Senate bills eliminate the deduction for state & local income taxes, but preserve the deduction for local property taxes – but limit it to $10,000.
Changes to the child tax credit:
Current law allows one to claim a $1,000 refundable tax credit for each dependent child under the age of 17. This credit starts to phase out when the taxpayer’s adjusted gross income goes over $75,000 for single filers; and $110,000 for married filing joint.
The House bill increases the credit to $1,600 and increases the AGI threshold subject to the phase out to $115,000 for single; $230,000 for MFJ.
The Senate bill increases the credit to $2,000 per child (however, only $1,000 is considered “refundable”, whereas the extra $1,000 is not). It also increases the age of the child to 18, up from the current age 17 cutoff. Lastly, if increases the AGI threshold of the phase out to $500,000 for married couples who file a joint return.
Alternative Minimum Tax:
The AMT tax was originally created in 1969 to prevent 155 uber-wealthy people from using deductions and credits to avoid paying any federal income tax whatsoever. Today, the AMT affects about 4.7 million tax payers – many of whom would not be considered “uber-wealthy” by most standards. Discussion about repealing it has been going on for years.
The House bill does, in-fact, repeal it. The original Senate bill also repealed it, but the final version of the bill keeps it in-tact while raising the amount of income exempt from it.
Charitable Giving Deduction:
Under current law you can only take a tax deduction for donating money or property to charities if you itemize your deductions on Schedule A. There are a number of rules that pertain to the type of property you’re giving as well as the type of charity that you’re making the gift to, however, in general, if you’re giving cash to a public 501(c)(3) charity, then you can deduct 100% of the gift, up to 50% of your adjusted gross income.
Both bills increase this amount up to 60% of AGI for cash contributions only.
Personally, I believe that this is of little benefit to the majority of people. Very few people give cash donations that exceed even 10% of their income, much less 50% or 60%!. This increased amount does virtually nothing to either 1) provide a tax benefit; or 2) encourage increased charitable giving. In fact, due to the substantial increase in the standard deduction, many more tax payers will find that they no longer will benefit from itemizing their deductions, and therefore will receive zero tax benefit from their charitable donations. However, when it comes right down to it, I think that people give with their hearts first and foremost. The tax-benefit of a gift is usually not what motivates someone to make it.
Of particular note, there is one negative provision in the House bill that will upset several of my friends who acquire OSU football season tickets this way. There is a special rule in the current law that allows a charitable deduction of 80% of the amount paid for the right to purchase tickets to athletic events (i.e. giving to one’s alma mater in order to gain eligibility to purchase season tickets). Both bills completely repeal this deduction allowance! I say “Boo!” to this!
Estate and Gift tax changes:
The current estate & gift tax laws allow a taxpayer to gift during life, or pass upon death, up to $5.49 million to someone other than a spouse or charity without owing an estate or gift tax. This “exclusion” amount increases each year by an inflationary rate. Amounts transferred above this threshold are subject to a 40% tax. If a decedent passes all of their assets to their spouse, then their “unused” exemption can be transferred to their surviving spouse and used when he or she passes away.
For 2018, the House and Senate bills both would double the exemption to $11.2 million, meaning that a married couple could transfer $22.4 million to the next generation with no tax.
The House bill goes further and lowers the gift tax rate to 35%, and then permanently repeals the estate and gift taxes for deaths after 2024.
Changes to education related items:
The Senate bill doesn’t touch on any education related items, but the House bill makes a number of changes. Two of the most notable ones are: 1). 529 accounts would now allow for up to $10,000 per year to be withdrawn and used for K-12 expenses; and 2). The current law allowing one to deduct up to $2,500 in school loan interest would be completely repealed.
While I like the change to the 529 accounts, I can’t fathom why the legislators would want to make it even harder for people to pay back their student loans. Of all the things to “nit-pick” on!
New provision for ABLE accounts:
ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families. They were recently created as a result of the passage of the “Stephen Beck Jr., Achieving a Better Life Experience Act of 2014” (aka the ABLE Act). These accounts are modeled after existing legislation covering 529 college savings accounts.
Both bills will allow 529 account balances to be rolled over into ABLE accounts, subject to some limitations. The Senate bill goes further allowing ABLE beneficiaries to contribute their own earned income funds to the account even after the $14,000 limit has been reached by gifts from others.
These are really good changes. The funds in ABLE accounts will not affect a person’s eligibility for SSI, Medicaid and other public benefits. These changes allow families to better plan for the future care of their disabled loved ones.
Changes to the taxation of pass-through business income:
Taxpayers who have ownership in a business (partnerships, S-Corporation or sole-proprietorship) where the net taxable income is “passed through” to the taxpayer’s individual tax return, currently are taxed on this income at the same rates that apply to all other income earned by the taxpayer. The two bills both lower the taxation for these business owners, however they do so in very different ways.
The House bill taxes a portion (generally 30%) of the qualifying business income at a top rate of 25%. All other income would be taxed at the individual tax rates. However, there is an exception: net-income from a passive business activity (e.g. rental real estate, or a passive ownership in a business that you are not actively involved in) would be fully eligible for the 25% rate.
A lower rate may apply to the first $75,000 for a married filing joint tax return ($37,500 for a single tax filer). The lower rate applied would be 11% in 2018 and 2019; 10% in 2020 and 2021; and then 9% in 2022 and after. However, this lower rate starts phasing out when the business income reaches $150,000 MFJ ($75,000 for a single filer).
Of particular note is that the top rate of 25% on 30% of the income does not apply to owners of certain personal service businesses (e.g. businesses involving the performance of services in the fields of health, law, engineering, architecture, accounting, consulting, financial services, or “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees”). However, owners of these businesses are allowed to qualify for the reduced rate on the first $75,000 of income described in the paragraph above (assuming their income doesn’t phase them out of it).
The Senate version allows the owner to deduct (therefore a 0% tax rate on) the lesser of 23% of qualifying business income or 50% of the W2 wages that the business pays to the owner. (This 50% of wages limitation is waived for taxpayers whose taxable income is under $500,000 if married, or $250,000 if single). This is to prevent owners of S-corp businesses from moving the bulk of their net income from wages to s-corp distributions.
However, I find it odd that the bill doesn’t specify that the 50% of wage limitation only applies to S-corps. Sole-proprietors and partners of partnerships aren’t technically supposed to pay themselves a W2 wage. So, if you follow this rule, then those particular pass-through entities (at least those making above the $500,000 ($250,000) income threshold) would have a 0% deduction. Either I’m missing something (and perhaps one of my CPA friends can explain it to me) or this fact was missed by the legislators and a technical correction will have to be made in the final bill.
Again, as in the House bill, some owners of personal service businesses are “discriminated against” (my opinion) participating in the full benefit of the deduction. However, the Senate here has graciously (read sarcastically) allowed owners of these types of businesses to take the full deduction if their taxable income is under the thresholds described above ($500,000 MFJ; $250,000 single). So, it’s only the personal service business owners with taxable income greater than these amounts that are discriminated against.
What I find unsettling about this “personal service business” exclusion in either bill, is that the President and members of congress have been “selling” their constituents on the idea that they were going to lower taxes for all businesses – including those that are pass-through entities. They recognized (correctly) that most “main street” businesses are not structured as C-Corporations. The fact, however, is that many “main street” businesses are actually personal service businesses. The National Federation of Independent Business stated that 85% to 90% of their 325,000 members would be ineligible for the pass-through rate under the House bill. So, it’s all “smoke and mirrors”, in my opinion – especially the way the House bill reads.
Senate Expiration Date:
All of the changes discussed thus far are made permanent by the House bill, however, in the Senate bill they all expire January 1, 2026 and revert back to current law.
All of the changes discussed henceforth are to be made permanent by both bills.
Changes to Retirement Plans:
Current law allows one to recharacterize a previously converted IRA to a Roth IRA. The deadline to do so is October 15th of the year following the year of conversion. Planning strategies have been born out of the ability to perform this recharacterization.
For example, let’s say that you decided to convert a traditional IRA to a Roth IRA in January 2017. The amount you converted will be added to your taxable income for 2017 when you file your taxes. Converting to a Roth is great when your investments go up in value post conversion because you’ve converted that growth from being taxable income (if it had stayed in the IRA) to tax-free income (via the Roth IRA). However, if your investments go down in value, it’s not a good feeling to pay taxes on, say, a $100,000 conversion amount that has dropped in value to $90,000 due to a market correction. So, what recharacterization allows you to do is wait until October 15, 2018 to “undo” the conversion as if it never happened, therefore eliminating the extra tax liability. (technically the tax is due on April 15, 2018 so if you recharacterize after that, but before October 15, you’ll file an amended return if you already filed on April 15).
Some investors have taken this strategy to higher levels of sophistication by splitting their conversion amount into multiple Roth IRAs with the purpose of investing each Roth IRA with a different investment strategy to see which ones make money (keep those) and which ones don’t (recharacterize those).
Both of the House and Senate bills would no longer allow people to recharacterize conversions. The House bill summary, put out by the House Ways and Means Committee, specifically sites this “gaming the system” and their interest in preventing it as the consideration for this provision. That’s unfortunate, as there are other, valid reasons for allowing recharacterization. Such as, if one’s overall financial situation changes drastically soon after performing a conversion – like losing your job.
Changes to selecting tax lot when selling investments:
Under current law, if a taxpayer has acquired shares of stock over time at different prices they are allowed to select specific “lots” of shares to sell to better control the amount of capital gains tax they might owe. Otherwise, the default method is to assume that the shares sold come from the oldest lot first, which usually are the shares with the lowest cost-basis. This default method is called “First In, First Out” or FIFO for short.
The House bill completely left this alone. However, the Senate proposal would take away the taxpayer’s ability to select specific lots, and makes the FIFO treatment mandatory.
I personally think this is very punitive on Americans who plan on using their taxable investment portfolios as a part of their retirement plan. Managing taxes during the distribution phase of one’s life is a critical component to a more secure retirement. Taking such an important tool away from retirees would be to their detriment.
Changes to the tax rate on C-Corporations:
Perhaps the biggest driving force behind this tax reformation, is the desire to lower the corporate tax rate, whereby making the U.S. a more favorable place to establish businesses. The rationale is that if the U.S. is more successful in luring business here, then that will grow the economy and bring more jobs at a higher growth rate than what it’s achieved in the recent past (over the past 10-20 years).
As we stand now, according to a September 2017 report published by the Tax Foundation entitled “Corporate Income Tax Rates around the World, 2017”, the U.S. has the fourth highest top marginal corporate income tax rate in the world, at 38.91%. The worldwide average top corporate income tax rates, across 202 tax jurisdictions, is 22.96%”
In my opinion, the U.S. has been behind the worldwide trend of lowering rates, and our country’s economic growth has suffered because of it. The positive effects of lowering the rate so late in the game may take some time for the effects to materialize, but many economists agree this will attract more and more businesses over time.
The House bill lowers the tax rate on most C-corporations to 20%, whereas Personal Service Corporations would be lowered to 25%. The House bill further repeals the Corporate version of the Alternative Minimum Tax.
The Senate bill lowers the rate on all C Corps to 20%, but the change wouldn’t take effect until 2019. It makes no changes to the corporate AMT.
Changes to international tax provisions:
Going hand-in-hand with lowering the corporate tax rate, the other driving force behind tax reform is motivating large US corporations, who collectively are holding $2.6 trillion in cash overseas, to bring that cash back to the US and put it to use.
Current law allows a foreign subsidiary that is owned by a U.S. company to avoid paying U.S. tax on its net income until the income is distributed as a dividend to the U.S. company.
The House and Senate bills both include a “deemed repatriation” provision which essentially taxes all of the previously un-taxed “earnings & profits” (E&P) of the foreign subsidiary (since 1987!) at a reduced rate of 14% for cash in the House bill (10% in the Senate bill), and an even further reduced 7% rate (5% in the Senate version) for E&P that has been reinvested back into the foreign subsidiary’s business (e.g. property, plant, equipment). The E&P would be reported on the 2017 tax return, but they can make an election to pay the tax liability over a period of up to 8 years.
Basically, the IRS is taxing it – even if the company doesn’t bring the cash back to the U.S. The idea is to effectively force these companies to bring the cash back to pay the tax, and invest in their U.S. operations.
This is all with good intentions. However, many newspapers like the Wall Street Journal and financial institutions like Bank of America-Merrill Lynch have conducted surveys asking the CEOs of these major companies what their companies will most likely do with the cash once it’s brought back. The number 1 response was that they will pay down debt. The 2nd most popular response was they would execute stock buybacks, where companies purchase some of their own shares to drive up the stock price. The 3rd response was mergers. Investments into new factories, more research, and hiring more employees were all very low on their list for how they will spend the money. So, it’s doubtful that this is going to have the effect on the economy that the bill supporters are hoping. However, it very well could have a positive effect on the stock market, so that will make investors happy.
Lastly, whether or not the bill will pay for itself has been a matter of controversy. Last Thursday the nonpartisan Joint Committee on Taxation released a report that estimated the cost of the Senate bill, even including the estimated effect of economic growth, would add $1 Trillion dollars to our National Debt over the next 10 years. My guess is that during the negotiations for the final bill, they will figure out a way to lower this cost. Remember, when this all started, everyone in support of tax reform was stressing that they needed to do it in a “revenue neutral” way. Well, how did we get here then?
I was listening to Bloomberg radio yesterday morning, and I heard a speaker (wish I caught his name to give him proper credit here) voice his opinion that this is a “political bill with economic consequences, and not an economic bill with political consequences”. I think that pretty much sums it up.
I do like a lot of these changes, and I (along with all of you, I’m sure) certainly hope that this spurs on economic growth more than the number crunchers are estimating. Otherwise, we’re digging ourselves into an even bigger hole that our future generations will be hard-pressed to deal with.
Disclaimer: The information above is not intended to be tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This information was developed from sources believed to be providing accurate information.