Rate Reduction and Deduction Cutdown: The Most Significant Changes in the U.S. Tax Legislation Introduced at the End of 2017
On December 20, 2017, Congress passed the Tax Cuts and Jobs Act of 2017 (TCJA), and President Trump shortly thereafter signed it. This law, most of which will become effective as soon as January 1, 2018, dramatically changes the tax environment of the United States. New financial planning strategies will emerge in the coming months and years.
The tax law signed just before Christmas was intended to make U.S. businesses more globally competitive. Its signature feature was a lowering of the corporate tax rate from 35 to 21 percent. While that and other features of the new law may positively impact the desirability of doing business in the United States, President Trump has a particular fascination with the trade deficit. The law changes so many things at once – from corporate rates to a repatriation tax to different depreciation rules to new individual rates – that it is exceedingly difficult to give a precise prediction on what exactly will change and how the economy will react in the longer perspective. The introduced tax changes will affect everything from how corporate assets are financed to how business is structured.
Certainly, the biggest beneficiaries of this legislation are corporations with high effective tax rates, because the corporate rate is dropping from 35% to 21%. Certain pass-through businesses will also see major reductions. Some LLCs, partnerships, S Corps, and sole proprietors will be able to deduct 20% of their qualified business income. Essentially, they will be paying taxes on only 80% of their revenue.
The personal exemptions are going away for taxpayers starting 2018 reporting year. That means for a family of three or more, the benefit of the standard deduction is completely offset by the $4,050 deduction it used to be able to take for each person on the return. In other words, if a taxpayer has two or more kids, you may actually be hurt by the new deduction/exemption amounts. On the other hand, in the bigger picture this tax experiment will run up the already high national debt by another $1.5 trillion.
Let’s try to review the main changes introduced by the Act for each type of tax to get the idea of how these changes will affect individuals and corporations.
- The Act keeps the seven income tax brackets but lowers tax rates. The US employees will see changes reflected in their withholding in February 2018 paychecks. These rates will revert to the 2017 rates in 2026.
- The Act creates the following chart. The income levels will rise each year with inflation. But they will rise more slowly than it was before since the Act uses the chained consumer price index. Over time that will move more people into higher tax brackets.
- The Act doubles the standard deduction. A single filer’s deduction increases from $6,350 to $12,000. The deduction for Married and Joint Filers increases from $12,700 to $24,000.
- The Act eliminates personal exemptions. Before the Act, taxpayers subtracted $4,150 from income for each person claimed. As a result, families with many children will pay higher taxes despite the Act’s increased standard deductions.
- The Act eliminates most itemized deductions.That includes moving expenses, except for members of the military. Those paying alimony can no longer deduct it, while those receiving it can. This change begins in 2019 for divorces signed in 2018.
- It keeps deductions for charitable contributions, retirement savings, and student loan interest. It might be smart for the taxpayers to try to incur these expenses in 2017 if possible.
- It limits the deduction on mortgage interest to the first $750,000 of the loan. Interest on home equity lines of credit can no longer be deducted. Current mortgage-holders aren’t affected.
- Taxpayers can deduct up to $10,000 in state and local taxes. They must choose between property taxes and income or sales taxes. This will harm taxpayers in high-tax states like New York and California. It is possible to prepay some of these taxes by the end of the year to deduct them in 2017.
- The Act expands the deduction for medical expensesfor 2017 and 2018. It allows taxpayers to deduct medical expenses that are 7.5 percent or more of income. Before the bill, the cutoff was 10 percent for those born after 1952. Seniors already had the 7.5 percent cutoff.
- The Act repeals the Obamacare taxon those without health insurance in 2019 (under current legislation the individuals who failed to buy health insurance plan were to pay a penalty). Without the mandate, the Congressional Budget Office estimates 13 million people would drop their health insurance plans. The government would save $338 billion by not having to pay their subsidies. But health care costs will rise because fewer people will get the preventive care needed to avoid expensive emergency room visits.
- The Act doubles the estate tax exemption to $11.2 million for singles and $22.4 million for couples. That helps the top 1 percent of the population who pay it. These top 4,918 tax returns contribute $17 billion in taxes. The exemption reverts to pre-Act levels in 2026.
- It keeps the Alternative Minimum Tax. It increases the exemption from $54,300 to $70,300 for singles and from $84,500 to $109,400 for joint. The exemptions phase out at $500,000 for singles and $1 million for joint. The exemption reverts to pre-Act levels in 2026.
Child and Elder Care
- The Act increases the Child Tax Creditfrom $1,000 to $2,000. Even parents who don’t earn enough to pay taxes can claim the credit up to $1,400. It increases the income level from $110,000 to $400,000 for married tax filers.
- It allows parents to use 529 savings plans for tuition at private and religious K-12 schools. They can also use the funds for expenses for home-schooled students.
- It allows a $500 credit for each non-child dependent. The credit helps families caring for elderly parents.
- The Act lowers the maximum corporate tax ratefrom 35 percent to 21 percent, the lowest since 1939. The United States has one of the highest rates in the world, but most corporations don’t pay that much tax. On average, the effective rate is 18%.
- It raises the standard deduction to 20% for pass-through businesses. This deduction ends after 2025. Pass-through businesses include sole proprietorships, partnerships, limited liability companies, and S corporations. They also include real estate companies, hedge funds, and private equity funds. The deductions phase out for service professionals once their income reaches $157,500 for singles and $315,000 for joint filers.
- The Act limits corporations’ ability to deduct interest expense to 30 % of income. For the first four years, income is EBITDA, but reverts to earnings before interest and taxes thereafter. That makes it more expensive for financial firms to borrow. Companies would be less likely to issue bonds and buy back their stock. Stock prices could fall. But the limit generates revenue to pay for other tax breaks.
- It allows businesses to deduct the cost of depreciable assetsin one year instead of amortizing them over several years. It does not apply to real estate.
- The Act stiffens the requirements oncarried interest profits. Carried interest is taxed at 23.8 % instead of the top 39.6 % income rate. Firms must hold assets for a year to qualify for the lower rate. The Act extends that requirement to three years. That might hurt hedge funds that tend to trade frequently. It would not affect private equity funds that hold on to assets for around five years. The change would raise $1.2 billion in revenue.
- The Act eliminates the corporate AMT.The corporate AMT had a 20 % tax rate that kicked in if tax credits pushed a firm’s effective tax rate below that level. Under the AMT, companies could not deduct research and development spending or investments in low-income neighborhood. Elimination of the corporate AMT adds $40 billion to the deficit.
- It advocates a change from the current “worldwide” tax system to a “territorial” system. Under the worldwide system, multinationals are taxed on foreign income earned. They don’t pay the tax until they bring the profits “home”. As a result, many corporations leave the profits overseas. Under the territorial system, they aren’t taxed on that foreign profit. They would be more likely to reinvest it in the United States. This will benefit pharmaceutical and high-tech companies the most.
- The Act allows companies to repatriate the $2.6 trillion they hold in foreign cash stockpiles. They pay a one-time tax rate of 15.5 % on cash and 8 % on equipment.
- It allows oil drilling in the Arctic National Wildlife Refuge. That’s estimated to add $1.1 billion in revenues over 10 years. But drilling in the refuge won’t be profitable until oil prices are at least $70 a barrel.
- It retains tax credits for electric vehicles and wind farms.
- It cuts the deduction for orphan drug research from 50 percent to 25 percent. Orphan drugs target rare diseases.
- The Act cuts taxes on beer, wine, and liquor. The Brookings Institute estimates that will lead to 1,550 more alcohol-related deaths each year. The study found that lower alcohol prices are directly correlated to more purchases and a higher death toll.
As mentioned above, it is very difficult to predict the outcome of the new tax reform; however, it is possible at this point to estimate who will get the most affected by the introduced changes to the tax legislation. It’s fair to say, that the new tax plan helps businesses more than individuals. Business tax cuts are permanent, while the individual cuts expire in 2025. Among individuals, it would help higher income families the most.The Act makes the U.S. progressive income tax more regressive. Tax rates are lowered for everyone, but they are lowered more for the highest-income taxpayers.
The Tax Foundation said those in the 20-80 percent income range would receive a 1.7 percent increase in after-tax income. Those in the 95-99 percent range would receive a 2.2 percent increase. The Tax Policy Center broke it down a little more. Those in the lowest-earning fifth of the population would see their income increase by 0.4 percent. Those in the next highest fifth would receive a 1.2 percent boost. The next two quintiles would see their income increase 1.6 percent and 1.9 percent, respectively. But the biggest increase, 2.9 percent, would go to those in the top-earning fifth. The increase in the standard deduction would benefit 6 million taxpayers. That’s 47.5 percent of all tax filers, according to Evercore ISI. But for many income brackets, that won’t offset lost deductions. The Tax Foundation said the Act will add almost $448 billion to the deficit over the next 10 years. The tax cuts themselves would cost $1.47 billion. But that’s offset by $700 billion in growth and savings from eliminating the ACA mandate. The plan would boost GDP by 1.7 percent a year. It would create 339,000 jobs and add 1.5 percent to wages.
The impact on the $20 trillion national debt will eventually be higher than projected. A future Congress will probably extend the tax cuts that expire in 2025.
An increase in sovereign debt dampens economic growth in the long run. Investors see it as a tax increase on future generations. That’s especially true if the ratio of debt to gross domestic product is near 77 percent. That’s the tipping point, according to a study by the World Bank. It found that every percentage point of debt above this level costs the country 1.7 percent in growth.
Many large corporations confirmed they won’t use the tax cuts to create jobs. Corporations are sitting on a record $2.3 trillion in cash reserves, double the level in 2001. The CEOs of Cisco, Pfizer, and Coca-Cola would instead use the extra cash to pay dividends to shareholders. In effect, the corporate tax cuts will boost stock prices, but won’t create jobs.
Overall, the barrage of soundbites and testimonials from Congressional Republicans and the Trump administration that the tax reform is primarily about assistance to the middle class and job creation don’t appear to correspond to reality. Wealthy individuals and corporations (in particular, multi-national ones) are almost certain to benefit first and foremost from the proposed changes. And given the restructuring of corporate tax rates, conventional corporations (C corps) may in fact become the structure of choice, replacing the LLC as the preferred entity form. Given the complications and extensive changes in the new law, it will take an extended amount of time to determine its true effect on individuals, business structures, and the debt level of the U.S. government. However, given the experiences with past legislative efforts to amend the tax code (and ostensibly reduce the tax burden with the hope of spurring growth), there will likely be numerous unexpected consequences that no one can predict at this point in time.
The tax advantage is defined as the reduction of the tax burden due to tax base reductions, granted tax deductions, tax benefits, application of lower tax rates, and the granted right for tax refund (credit) or tax reimbursement from the budget.
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