Tax Reform: Insights on the Impact for Individual Taxpayers

The House Ways and Means Committee’s tax reform proposal (the Tax Cuts and Jobs Act (the “bill”)) released November 2, 2017, would have significant impact on individual income taxpayers. The individual income base-broadening provisions of the bill are estimated to increase taxes by $3.0 trillion over 10 years, largely attributed to the elimination of personal exemptions. Meanwhile, the changes in individual tax rates, a repeal of the Alternative Minimum Tax (“AMT”), an increase to the Child Tax Credit, and a new family tax credit are expected to decrease taxes by $3.3 trillion over 10 years.

The detail of some of the proposed changes to the individual income tax system can be found below.

 

Overall changes to income taxes and rates

Individuals would see both a reduction and simplification of their individual income tax rates.

Current law:

Seven individual federal income tax brackets apply for tax year 2017: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The applicable tax bracket for an individual taxpayer depends upon the person’s filing status and income level, as follows:

Married filing jointly (MFJ) Head of Household (HoH) Single Estate & trust
10% <$18.650 <$13,350 <$9,325 N/A
15% <$75,900 <$50,800 <$37,950 <$2,550
25% <$153,100 <$131,200 <$91,900 <$9,150
28% <$233,350 <$212,500 <$191,650 N/A
33% <$416,700 <$416,700 <$416,700 N/A
35% <$470,700 <$444,500 <$418,400 <$12,500
39.6% >$470,700 >$444,500 >$418,400 >$12,500

In addition, current law taxes net long-term capital gain and qualified dividend income (QDI) at either 0%, 10% or 15%, depending on the ordinary income tax bracket of the taxpayer:

0% capital gains rate Taxpayers in the 10% or 15% rate brackets
15% capital gains rate Taxpayers in the 25%, 28%, 33% or 35% tax brackets
20% capital gains rate Taxpayers 39.6% rate bracket

Proposal:

The bill would reduce the number of tax brackets to four: 12%, 25%, 35%, and 39.6%. The applicable tax bracket for an individual taxpayer depends upon the person’s filing status and income level, as follows:

MFJ HoH Single Estate & trust
12% <$90,000 <$67,500 <$55,000 <$2,550
25% <$260,000 <$200,000 <$200,000 <$9,150
35% <$1mil <$500,000 <$500,000 <$12,500
39.6% >$1m >$500,000 >$500,000 >$12,500

The bill also proposes to adjust the inflation adjustment mechanism for the brackets. The benefit of the 12% rate would be phased out for high-income taxpayers. For married couples filing jointly, this phase out begins at adjusted gross income (AGI) in excess of $1.2 million. For single and head-of-household taxpayers, the phase out begins at AGI in excess of $1 million.

The bill would apply three tax rates (0%, 15% and a 20%) to capital gains income of individuals (indexed for inflation), based on the amount of gain and the filing status of the taxpayer, as follows:

MFJ HoH Single Estates & Trusts
0% Rate <$77,200 <$51,700 <$38,600 <$2,600
15% Rate <$479,000 <$452,400 <$425,800 <$12,700
20% Rate >$479,000 >$452,400 >$425,800 >$12,700

Effective date:

These provisions would be effective for tax years beginning after 2017. According to JCT, the provision would reduce revenues by $1,051.2 billion over 2018-2027.

Summary of impact:

The seven brackets were reduced to four brackets, and the spacing between the brackets are much wider. The lower rates would essentially mean a tax cut for all taxpayers (except those who were already not paying income tax). The phase-out of the 12% bracket is an attempt to preserve progressivity. Interestingly, the phase out the 12% bracket is based on AGI, not taxable income, so the 12% phase out would, in many cases, begin while the taxpayer is in the 35% bracket.

Although a discussion of the consumer price index (CPI) is not warranted in this alert, the chained CPI takes into consideration substitutions consumers make in response to rising prices of certain goods and services. The result is that the brackets will generally rise slower than they otherwise would under the CPI.

Another thing that must be kept in mind is the Net Investment Income Tax (NIIT). The bill did not propose to repeal the tax. However, the changes to items of income and deduction would impact NIIT. In fact, it is likely that NIIT liabilities will increase as deductions are disallowed. As NIIT liabilities increase, the feasibility of repeal become more difficult because of the amount of tax revenue that would be eliminated will increase.

 

Individual taxpayers would see simplification via a repeal of the alternative minimum tax

Current law:

Current law requires taxpayers to compute their income tax obligation in two ways — to determine both the regular income tax amount and the alternative minimum tax (AMT) — and to remit the higher of those two amounts as their income tax liability for the year. For individual taxpayers, estates, and trusts the two AMT brackets are 26% (applied to the first $182,500 of AMT income) and 28% (applied to AMT income over $182,500).

Proposal:

The bill would repeal the AMT. Taxpayers with AMT credit carryforwards generally would be permitted to claim a refund of 50% of the remaining credits in the 2019, 2020, and 2021 tax years, and could claim any remaining credits in the 2022 tax year.

Effective Date:

The proposal would be effective for tax years beginning after 2017. According to the Joint Committee on Taxation (JCT), repeal of the individual AMT would reduce revenues by $695.5 billion over the 2018-2027 time period, and repeal of the corporate AMT would reduce revenues by $40.3 billion over the 2018-2027 time period.

Summary of impact:

The requirement that taxpayers compute their income for purposes of both the regular income tax and the AMT is one of the most far-reaching complexities of the current Code. According to JCT, the AMT affected about 4.5 million American families in 2017. The AMT is particularly burdensome for small businesses, which often do not know whether they will be affected until they file their taxes and therefore must maintain a reserve that cannot be used to hire, expand, and give raises to workers. In its 2001 tax simplification report, JCT concluded that the AMT “no longer serves the purposes for which it was intended,” and recommended its repeal.

Tax planning note:

For taxpayers who expect to fall under the AMT for the 2017 tax year, it may be prudent to accelerate ordinary income because such accelerated items may be subject to an effective rate close to 28%, whereas the rates proposed for 2018 might be higher. The income that is best to accelerate are items that are not taxable for state income tax purposes (e.g., cashing in US savings bonds with accrued interest or converting IRAs to Roth IRA when the state does not tax the rollover). If the income subject to the acceleration is also subject to state income tax, then one must consider when the associated state income tax payment should be made in light of the potential for the deduction to be disallowed in 2018.

 

Modifications to deductions for individual taxpayers

Individual taxpayers would receive a major enhancement of the standard deduction, which will largely decrease the number of taxpayers opting to take the itemized deduction.

Current law:

Under current law, AGI is reduced by either the standard deduction or itemized deductions, if the taxpayer chooses to itemize. For the 2017 tax year, the standard deduction was:

— $6,350 for single individuals and married individuals filing separately

— $9,350 for heads of households

— $12,700 for married couples filing jointly

Proposal:

The bill proposes to increase the standard deduction to:

— $12,000 for single filers and married individuals filing separately

— $18,000 for single filers with at least one qualifying child

— $24,000 for married couples filing jointly and surviving spouses

Effective date:

The provision would be effective for tax years beginning after 2017. According to JCT, the provision would reduce revenues by $921.4 billion over the 2018-2027 time period.

Summary of impact:

The increase in the standard deduction will help achieve substantial simplification by reducing the number of taxpayers who choose to itemize their deductions from roughly one-third under current law to fewer than 10% under the legislation, according to the JCT.

Individual taxpayers would no longer be entitled to and personal exemptions.

Current law:

Current law allows a taxpayer to claim a personal exemption for the taxpayer, his or her spouse, and any dependents. The amount that may be deducted for each personal exemption in the 2017 tax year is $4,050. The personal exemption begins to phase out for taxpayers at certain income levels: single taxpayers beginning at $261,500; head-of-household beginning at $287,650; married couples filing jointly beginning at $313,800; and married taxpayers filing separately beginning at $150,000.

Proposal:

The bill would repeal the personal exemption deduction and phase-out.

Effective date:

The repeal would be effective for tax years beginning after 2017. According to JCT, the provision would increase revenues by $1,562.1 billion over the 2018-2027 time period.

Summary of impact:

The personal exemption for the taxpayer and taxpayer’s spouse would be consolidated into a larger standard deduction. The personal exemption for children and dependents would be consolidated into an expanded child tax credit and a new family tax credit.

Interestingly, the bill also repeals the personal exemption for estates and trusts. However, estates and trusts are not entitled to a standard deduction, so the repeal of the exemption is simply a small tax increase on those entities.

 

Modifications to itemized deductions

Individual taxpayers would be impacted by a significant modification to the deduction for state income and property tax deduction.

Current law:

Current law provides taxpayers who itemize deductions to claim a deduction for state and local government income and property taxes paid during the tax year. Rather than deducting state and local income taxes, an itemizing taxpayer may choose to claim an itemized deduction for state and local sales taxes paid.

Proposal:

The provision would (1) repeal the itemized deduction for foreign, state and local income and sales taxes generally for individuals; (2) limit itemized deductions for real property taxes paid on personal use property up to $10,000; and (3) continue to allow a deduction for state and local property taxes (real or personal) paid or accrued in carrying out a trade or business or producing income.

Effective date:

The provision would be effective for tax years beginning after December 31, 2017.

Summary of impact:

This proposal eliminates a tax benefit that largely subsidizes higher spending at the state and local level.

In the context of property taxes, the bill did recognize that property taxes associated with businesses and for-profit activities remain fully deductible. Only real estate taxes on personal use real property located in the United States are limited to $10,000. Personal property tax on personal use property (such as state automobile taxes) are disallowed entirely. Intuitively, one might think that Schedule A itemized deductions would be limited to $10,000, but that would not be the case. Real property held for investment, but not rented, would still enjoy full deduction on Schedule A. Additionally, the bill provides that foreign real property taxes would be nondeductible, which would primarily affect citizens working abroad, which in turn, would likely end up being borne by their employer due to comprehensive equalization agreements.

Outside of noting the inequitable outcome between passthrough businesses and corporations regarding the state tax deduction, the bill reduces the corporate tax rate to 20% (which is imposed on taxable income after the deduction for state taxes); the passthrough rate on business income is proposed to be 25% without the deduction for state taxes. This inequity may contribute to some passthrough businesses evaluating whether the corporate form may be worth considering.

Tax planning note:

For taxpayers that do not expect to be subject to the AMT in 2017, a planning opportunity would be accelerate the payment of state and local income tax and property taxes. However, taxpayers need to keep in mind that Revenue Ruling 82-208 held that a cash basis taxpayer may not deduct an estimated state income tax payment if on the date of payment the taxpayer could not reasonably determine, in good faith, that there is an additional state income tax liability. It further indicated that where a taxpayer, pursuant to state law, makes an estimated payment of state income taxes that it reasonably determined in good faith at the time of payment, the payments are deductible.

Individual taxpayers would lose the deduction for casualty losses.

Current law:

Current law allows a taxpayer who itemizes deductions to claim a deduction for personal casualty losses, including property losses from fire, storm, other casualty or theft, for amounts that exceed 10% of AGI.

Proposal:

The provision generally would repeal the personal casualty loss deduction, although deductions for casualty losses associated with special disaster relief legislation would not be affected.

Effective date:

The repeal would be effective for tax years beginning after 2017.

Implications:

In a year in which Hurricanes Irma, Maria and Harvey amounted to the largest casualty losses in US history,it is perplexing why Congress would propose to eliminate deductions for personal casualty losses. Additionally, for some in this country, the effects of high profile Ponzi schemes are still affecting their lives. Although in many instances, personal casualty losses are covered by insurance, the loss of this deduction will still hurt those who are caught in various schemes, such as Ponzi schemes or internet fraud. If these deductions are eliminated from the Code, it is highly likely Congress may wind up reconsidering in the wake of the next natural disaster or financial fraud scandal.

Individual taxpayers would see major changes to mortgage interest deduction and exclusion of gain from sale of a principal residence

Current law:

Current law allows a taxpayer who chooses to itemize deductions to claim a deduction for interest paid on the mortgage for the taxpayer’s principal residence and one other residence (second home). Mortgage deductions may be claimed on interest payments on up to $1 million in acquisition indebtedness and up to $100,000 in home equity indebtedness. However, under the alternative minimum tax (AMT), a taxpayer may not claim a home equity mortgage interest deduction.

Additionally, current law allows a taxpayer to exclude from gross income a limited amount of gain on the sale of a principal residence. For joint filers, up to $500,000 in gain may be excluded; for single filers, the limit is $250,000. The taxpayer must have owned and used the property as his principal residence for at least two of the last five years, and may claim the exclusion once every two years.

Proposal:

The mortgage interest provision proposes to eliminate the mortgage interest deduction for home equity loans and mortgages on second homes. For mortgages on principal residences acquired after November 2, 2017, interest would be deductible on up to $500,000 in acquisition indebtedness.

The exclusion of gain provision would maintain the exclusion but require a taxpayer to own and use the home as his principal residence for five out of the last eight years. The exclusion could be used once every five years, and would be phased out by one dollar for every dollar by which the taxpayer’s AGI exceeds $250,000 for single filers and $500,000 for joint filers.

Effective date:

The mortgage interest provision would apply to mortgages acquired after November 2, 2017. The home sale exclusion changes apply to closings occurring after December 31, 2017 (regardless of whether the contract was in force prior to the release of the bill).

Summary of impact:

These provisions of the bill will likely be contested. The grandfathering of existing mortgages is helpful, but the elimination of interest deductions for mortgages on second homes and home-equity intendedness is not. These later two types of mortgages would lose deductibility immediately.

On the sale exclusion side, this provision would merely restore the holding period requirement to what it was prior to 1978. Regardless of the policy, the modification to the home sale exclusion came as a bit of a surprise. Increase of the holding and use period from five years and two years to eight years and eight years will have a moderate impact, but the really surprising aspect is the phase-out of the deduction altogether.

Individual taxpayers would see slight positive changes to the deduction for charitable contributions

Current law:

Current law allows a taxpayer who itemizes deductions to claim deductions for charitable contributions made by the last day of the tax year. The deduction is limited to a certain percentage of the taxpayer’s AGI, which varies depending on the type of property contributed and the type of tax-exempt organization to which the donation is made.

To claim a charitable deduction for a contribution of $250 or more, the taxpayer generally must provide the IRS with a contemporaneous written acknowledgement by the donee organization. This requirement does not apply if the donee organization files a return with the required information.

Proposal:

The provision would change a number of rules applicable to the charitable contribution deduction, including:

— Imposing a 60%-limitation for cash contributions to public charities and certain private foundations

— Adjusting the deduction for mileage driven for charitable purposes to a “rate [that] takes into account the variable cost of operating an auto mobile”

— Repealing the exception that relieves a taxpayer from obtaining and providing a contemporaneous written acknowledgement for contributions over $250 if the donee organization files a return with the required information

Effective date:

The provision would be effective for tax years beginning after 2017.

Summary of impact:

These provisions may come as a welcome surprise to taxpayers: (a) indexing the charitable mileage rate for inflation (which was well overdue) and (b) increasing cash donations to 60% of AGI. In general, to deduct a gift to a charity, the giving of the gift must be with charitable intent — it is debatable whether this intent exists regarding the purchases of tickets to gaming events.

There was no change to the charitable contribution deduction under Section 642(c) for estates and trusts.

Individual taxpayers would no longer be entitled to deduct medical expense deduction

Current law:

Current law allows a taxpayer who itemizes deductions to claim an itemized deduction for out-of-pocket medical expenses for the taxpayer, a spouse and dependents to the extent the expenses exceed 10% of the taxpayer’s AGI.

Proposal:

The bill proposes to repeal the itemized deduction for medical expenses.

Effective date:

The repeal would be effective for tax years beginning after 2017.

Summary of impact:

The repeal of the medical expense deductions came as a bit of a surprise. The individuals who are largely impacted by this provision are those who are chronically ill, such as those with special needs and those in assisted living and acute care nursing homes.

Individual taxpayers would lose deduction for unreimbursed business expenses

Current law:

Current law allows a taxpayer to claim a deduction for certain trade or business expenses, even if the taxpayer does not itemize.

Proposal:

No itemized deductions would be permitted for expenses attributable to the trade or business of performing services as an employee.

Effective date:

The provision would be effective for tax years beginning after 2017.

Summary of impact:

The explanation accompanying the bill notes that, in conjunction with an increased standard deduction and lower overall tax rates, the provision would simplify the tax laws for taxpayers who currently claim deductions for employee business expenses. Keeping records of these expenses is often very burdensome for taxpayers, and this current-law deduction also poses administrative and enforcement challenges for the IRS.

The following common unreimbursed expenses, listed in IRS Publication 529, Miscellaneous Deductions, are examples of expenses that will become nondeductible under this proposed rule:

— Business bad debt of an employee

— Business liability insurance premiums

— Damages paid to a former employer for breach of an employment contract

— Depreciation on a computer your employer requires you to use in your work

— Dues to a chamber of commerce if membership helps you do your job

— Dues to professional societies

— Educator expenses

— Home office or part of your home used regularly and exclusively in your work

— Job search expenses in your present occupation

— Laboratory breakage fees

— Legal fees related to your job

— Licenses and regulatory fees

— Malpractice insurance premiums

— Medical examinations required by an employer

— Occupational taxes

— Passport for a business trip

— Repayment of an income aid payment received under an employer’s plan

— Research expenses of a college professor

— Rural mail carriers’ vehicle expenses

— Subscriptions to professional journals and trade magazines related to your work

— Tools and supplies used in your work

— Travel, transportation, meals, entertainment, gifts, and local lodging related to your work

— Union dues and expenses

— Work clothes and uniforms if required and not suitable for everyday use

— Work-related education

This provision may ultimately cause employers to pick up more of these costs as reimbursements. It would not be hard to imagine that this provision would likely be a new negotiating point for employers and employees operating under collective bargaining agreements.

While there are several components of the bill that will be contested during its path to becoming enacted law, we do believe that many of the proposals included above appear in line with expectations of practicing professionals and can be relied upon to facilitate thoughtful conversations among taxpayers and their tax advisors. At Caroprese & Company, we stand ready to assist you in interpreting the recent tax reform proposal so that you can have a clear understanding of its impact on you and your family. As always, please feel free to contact me directly at 201-591-1783 or bc@caroprese.co.

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