Following the Path to Tax Reform
As both the House and Senate have now passed tax reform proposals, you might be interested in an overview comparing the proposed changes so you’ll understand what the proposals entail as you follow the debate and won’t have to rely on politically motivated analysis by the various media sources. It is important to understand that the tax reform proposals are only an overall framework of the tax legislation that will be formulated later by congressional committees. So, it only provides the “big picture,” with details to be added later. However, the devil is always in the details, and you frequently have to read between the lines and listen to and read comments by Washington insiders to glean additional detail. Based upon that, the following are some of the provisions of the proposed tax reform that will apply to individual taxpayers and small businesses.
Current Law: A deduction from adjusted gross income (AGI), called an exemption allowance, is permitted for the filer of the return, his or her spouse if filing jointly, and each dependent claimed on the return. For 2017, each exemption allowance is $4,050. So, for example, a married couple filing jointly with two dependent children would be entitled to an exemption allowance of $16,200. However, the exemption deduction phases out for higher-income taxpayers.
Proposed Law: Personal exemptions would be eliminated in both the House and Senate bills, but child and other dependent credits might take their place, as described later in this article.
Current Law: The standard deduction is for taxpayers without enough deductions to file a Schedule A and itemize their deductions. Currently a standard deduction is set for each filing status and is adjusted for inflation each year. For 2017, the standard deduction is $6,350 for single and married separate, $9,350 for head of household, and $12,700 for married joint and surviving spouse. There are also add-on amounts for each filer and spouse who is age 65 or over, plus an additional amount for blindness.
Proposed Law: The House and Senate bills would replace both the current standard deduction and the personal exemptions with new higher standard deductions (about $12,000 for individual filers and $24,000 for married couples filing jointly).
When the proposed higher standard deductions were first announced some months ago, those using the standard deduction were excited to think their standard deductions would be roughly doubled. But now that we have a few more details, we find that personal exemptions would no longer be allowed, which changes the outcome significantly. The proposed change favors the smaller family size (those with more dependents could lose out), but this theoretically should be compensated for with a larger and partially refundable child tax credit that is discussed below.
Current Law: Medical deductions are allowed to the extent that they exceed 10% of the taxpayer’s AGI, tax deductions for state and local (city) income taxes or sales tax, plus real and personal property taxes. Also included is interest paid on qualified first and second home mortgage acquisition and equity debt, provided the acquisition debt doesn’t exceed $1 million and the equity debt isn’t over $100,000. The debt amounts of the first and second homes are combined for this limitation. Other categories of itemized deduction are charitable contributions and miscellaneous itemized deductions.
Proposed Changes: The House tax reform would eliminate all deductions except for charitable contributions and those that encourage home ownership, such as home mortgage interest (but lowering the debt ceiling to $500,000). The Senate bill keeps the debt ceiling at $1,000,000 but disallows an interest deduction related to home equity loans.
There has been pushback from members of Congress whose constituents reside in states that impose an income tax on their residents. Taking away the ability to deduct state and local income tax, referred to as the SALT deduction, would most significantly impact taxpayers living in states that have income taxes, and thus they would be double-taxed on the same income. All but seven states have income tax, with California, New York and New Jersey imposing the highest rates. The Senate bill also eliminates the deduction for state, local and sales tax but does allow a deduction for up to $10,000 for property taxes.
Eliminating medical deductions will significantly impact senior citizens who require expensive elder care and taxpayers who incur extraordinary medical expenses. The Senate bill would keep the deduction for medical expenses and lower the AGI threshold percentage from 10% back to 7.5% for 2017 and 2018. It also repeals the Obamacare mandate. The House version does not.
Individual Tax Rates:
Current Law: There are seven tax rates (10%, 15%, 25%, 28%, 33%, 35% and 39.6%), with the tax progressively increasing as the taxpayer’s taxable income increases. Each tax rate is applied to ever-increasing ranges of taxable income, referred to as tax brackets, with the 2017 top brackets kicking in at $418,400 for single taxpayers and $470,700 for married taxpayers filing jointly.
Proposed Changes: The House tax reform would reduce the number of tax rates to four: 12%, 25%, 35% and 39.6%. The Senate bill keeps the seven tax brackets but lowers the rates in most of them. The two proposals have different ranges of taxable income that these rates will apply to, making a quick comparison between the current law and the proposed changes tedious.
Child Tax Credit (CTC)
Current Law: Allows a tax credit of $1,000 for each qualifying child dependent under the age of 17. The credit is generally nonrefundable (meaning it can only offset your tax liability and any excess is lost). However, when a taxpayer’s income is low or there are three or more qualifying children, a portion of the credit is refundable. The credit is also phased out for higher-income taxpayers.
Proposed Changes: The House reform would increase the amount of the credit to $1,600 (Senate bill increases to $2,000 and allows it for children under 18) but both keep the first $1,000 of the CTC refundable. It would also add a nonrefundable credit of $300 (Senate bill adds $500) for other dependents of the taxpayer that do not meet the child criteria. This presumably eliminates the current complicated calculation for the refundable portion of the child tax credit. The income phaseout ranges are expanded so more taxpayers will be eligible for the credit. These adjustments to the CTC are touted to make up for the loss of personal exemptions.
Gain on Sale of Principal Residence
Current Law: Capital gains resulting from the sale of your home can be excluded up to $250,000 ($500,000 for married taxpayers) provided you have owned and lived in the residence for two of the past five years. This exclusion can be used every two years.
Proposed Changes: Both the House and the Senate bills change the time lived in requirement to five of the last eight years and only allow for the exclusion once every five years.
Alternative Minimum Tax (AMT)
Current Law: The AMT was originally initiated to keep higher-income taxpayers from benefiting from certain tax provisions. Over the years, inflation has caused the AMT to significantly impact more taxpayers than originally intended. Determining whether the AMT applies and computing the tax adds a layer of complexity to preparing the return.
Proposed Changes: The House reform would eliminate the AMT. The Senate bill maintains it but raises the exemption threshold.
Current Law: The current code imposes a 40% tax on the estate of a decedent whose estate’s value exceeds $5.49 million. The $5.49 million is adjusted down for certain gifts made during the decedent’s lifetime. Beneficiaries of estates receive inheritances at the fair market value of the property inherited as of the decedent’s date of death. Thus, beneficiaries who inherit property and then sell it are subject to tax only on the appreciation from the time they inherited the property.
Proposed Changes: The House reform essentially doubles the exemption amount and would eliminate the estate tax in 2024. Unanswered in the proposal is whether a beneficiary will continue to receive inherited property at fair market value or whether the heir will inherit the decedent’s basis in the property. If the latter, then when the beneficiary sells the property the beneficiary will be stuck with paying income tax on the entire appreciation in value from the time the property was acquired by the decedent. Also unanswered is whether the gift tax will continue to apply. The Senate bill keeps the estate tax but doubles the exemption amount.
Top Tax Rate for Small Businesses
Current Law: At present, business income from a Schedule C, LLC, Partnership and S-Corporation is passed through to the owner of the business and included on his or her 1040 individual return and taxed at rates ranging from 10% to 39.6%.
Proposed Changes: As mentioned previously, the House proposed changes would reduce the current seven tax rates to four. For pass-through businesses, the proposed changes limit the tax rate on pass-through small business income to a maximum 25%. Unfortunately, the term “small business” is not defined in the proposal and it is not available to those providing professional services. This proposed change would favor successful businesses that would otherwise be subject to the highest proposed tax rates. The Senate bill also lowers taxes for pass-through businesses but does it by allowing individuals to exclude 23% of their pass-through income (subject to limitation for service businesses). Special anti-abuse rules go along with these changes.
Expensing Business Purchases
Current Law: Generally, capital purchases by a business, such as machinery, vehicles, or computer systems, must be depreciated (written off) over their useful lives—usually 3, 5 or 7 years for most purchases by small businesses. A special allowance, usually referred to as bonus depreciation, is available in the first year for certain types of property. There is also a provision that allows expensing up to $510,000 worth of purchases in lieu of depreciating the cost of the property.
Proposed Changes: The House reform would allow 100% first-year expensing of capital purchases (other than structures) after September 27, 2017. The full expensing provision would not be permanent, but would be in the tax code for a minimum of five years. A future Congress could decide to extend the provision or make it permanent. The Senate bill also covers five years at the 100%, but then continues, phasing down by 20 percentage points over each subsequent year until fully utilized.
Both the House and the Senate cut the top corporate tax rate to 20% – which is below the 22.5% average of the industrialized world – with the intent to make U.S. businesses more competitive with their foreign rivals. Under the House reform, corporate alternative minimum tax would also be eliminated. Not so with the Senate bill.
The two tax reform proposals are now in conference committee to be reconciled and several may change in the process. The current consensus is that almost all the changes would not be effective until 2018. We hope this provides you with insight into the proposed tax reform.