Summary of the Tax Cuts and Jobs Act
On November 2, the House of Representatives released its long-awaited tax bill, referred to as the Tax Cuts and Jobs Act. After debate in the House Ways and Means Committee, scheduled for this week, the authors of the bill hope that the full House will pass the bill by November 17, after which point it would move to the Senate Finance Committee for consideration.* The Administration’s goal is to have the bill signed into law before year-end.
The 429-page bill proposes a number of sweeping and fundamental changes to the tax code, both with regard to individuals and businesses. In order to stay below the $1.5 trillion limit established in the recent budget reconciliation, some of the proposed changes are temporary or will be phased in over time. According to the Joint Committee on Taxation, the new law squeaks in just under the limit, adding $1.487 trillion to the federal deficit over ten years.
The bill is unlikely to be adopted in its current form. Indeed, certain provisions have already been modified in the Committee mark-up, and many industry groups and lobbyists, including the home-builder and real estate lobbies, various small business lobbies, and organizations supporting nonprofits, have raised objections to various aspects of the bill. In addition, it remains to be seen whether political tension caused by the compressed timeline imposed for passing the bill, along with recent election day results, will facilitate or further hamper the process.
The bill contains scores of important and wide-reaching changes—far too many to summarize here—but some of the key provisions include the following:
Fewer Tax Brackets. The bill proposes a reduction in the number of brackets from seven to four. The tax rates for the proposed brackets will be 12%, 25%, 35%, and 39.6%. For a married couple filing a joint tax return, the 25% rate applies to income above $90,000; the 35% rate applies to income above $260,000; and the 39.6% rate applies to income above $1 million. For single filers, the 25% rate applies to income above $45,000; the 35% rate applies to income above $200,000 (or $130,000 if married filing separately); and the 39.6% rate applies to income above $500,000.
Increased Standard Deduction. The bill proposes to essentially double the standard deduction. For single filers in 2018, the standard deduction will increase from $6,500 to $12,200. For joint returns the standard deduction will be $24,400, up from $12,700. Increasing the standard deduction makes it less likely that individuals will itemize deductions.
Elimination of the Deduction for Personal Exemption. The bill proposes to repeal the personal exemption beginning in 2018. Currently, for a married couple with two qualifying children, the personal exemption would result in a deduction of $16,200 that would be available in addition to either the standard or the itemized deduction.
Changes to Itemized Deductions. The bill proposes to eliminate certain itemized deductions beginning in 2018. These include deductions for medical expenses, personal casualty losses (e.g., fire, flood, etc.), theft losses, tax preparation expenses, and unreimbursed employee expenses. In addition, the bill eliminates the deduction for payment of state and local income taxes and sales tax. The deduction for payment of property tax will remain, but will be capped at $10,000. New rules would also apply to the mortgage interest deduction. A deduction would only be available for interest paid with respect to a taxpayer’s primary residence—no more deductions for paying mortgage interest on vacation homes. In addition, the limitation on indebtedness with respect to which mortgage interest is paid would be reduced from $1 million to $500,000.
Repeal and Modification of Other Deductions and Exclusions. Beginning in 2018, the bill would repeal or modify numerous above-the-line deductions and certain exclusions. For example, the exclusion of gain related to the sale of a principal residence would now require the taxpayer to reside in the home for five out of the past eight years, instead of two out of the last five. In addition, in order to create a new American Opportunity Tax Credit, the bill would consolidate or repeal the current education incentives. Some of the well-known deductions and exclusions that would be repealed include those for:
- Moving expenses;
- Contributions to medical savings accounts;
- Employer contributions to medical savings accounts;
- Dependent care assistance programs;
- Adoption assistance programs;
- Interest on education loans;
- Qualified tuition and related expenses;
- Interest on U.S. savings bonds used to pay higher education;
- Qualified tuition reduction programs; and
- Employer-provided education assistance programs.
Reduced Income Tax Rate for Pass-Through Businesses. The bill proposes that a portion of net income distributed by a pass-through entity and derived from active business activity may be treated as “business income” and subject to a maximum tax rate of 25%. Currently, such income is generally treated as compensation and is subject to ordinary income tax rates, up to a maximum of 39.6%. The calculation of business income is made by reference to the “capital percentage.” A discussion of how the capital percentage is computed is beyond the scope of this article, but the default rule is that the capital percentage is equal to 30 percent, meaning that 30 percent of pass-through income would be treated as business income and taxed at the 25 percent rate, and the remaining 70 percent would be treated as wages and taxed at ordinary income rates.
With regard to income derived from passive activities, the bill provides that all such income would be treated as business income, and thus taxed at the 25 percent rate. Interestingly, the bill also provides that pass-through income paid to individuals who perform personal services (e.g., accountants, engineers, lawyers, consultants, etc.) is not eligible for treatment as business income. Not surprisingly, the bill also contains certain anti-abuse rules to prevent taxpayers from attempting to recharacterize wages as business income.
Reduced Corporate Income Tax Rate. The bill would reduce the top corporate income tax rate from 35 percent to 20 percent. To maintain a consistent structure with the pass-through changes discussed above, personal service corporations would still be subject to a flat tax rate of 25 percent.
Elimination of the Alternative Minimum Tax. The bill proposes to eliminate the alternative minimum tax (AMT). The AMT is a separate tax calculation that applies to taxpayers who have relatively high incomes (typically more than $200,000) but are able to avail themselves of certain tax benefits in order to reduce their tax liability. The AMT ensures that such taxpayers still pay a minimum amount of tax. The AMT has been criticized because it can sometimes ensnare certain taxpayers who were perhaps not the proper target of the law. However, there is no doubt that most of the benefit resulting from repeal of the AMT will go to high-income earners.
Repeal of the Federal Estate Tax. Under current law, an individual is entitled to an inflation-adjusted exclusion from federal estate tax. In 2018, the exclusion amount is $5.6 million per person or $11.2 million for a married couple. As a result of these exclusions, only 0.2 percent of all estates pay federal estate tax. The bill proposes to double the base exclusion amount to $11.2 million per person and $22.4 million per couple in 2018. The estate tax would remain in place through 2023, but then would be repealed in its entirety in beginning in 2024 (as would the generation-skipping transfer tax). Surprisingly, the bill preserves the step-up in basis that applies to most property held at death, making this change in the law a have-your-cake-and-eat-it-too proposition for the wealthiest Americans.
Because of the wide variety and range in magnitude of the proposed tax changes, it is difficult to predict how a typical taxpayer might be affected. But in broad terms, it is clear that businesses, high-income earners, and taxpayers who have amassed significant wealth are the primary beneficiaries of this bill. According to the tax model at the Open Source Policy Center, the top 10 percent of income earners will enjoy approximately 53 percent of the overall tax benefit from 2018 through 2026, whereas income earners in the bottom 50 percent will only receive approximately 7 percent of the overall tax benefit. Stated differently, individuals who earn more than $1 million per year will receive approximately 27 percent of the overall tax benefit from 2018 through 2026, while individuals who earn less that $50,000 per year will receive approximately 9 percent of the overall tax benefit during that same period.
Sadly, the biggest losers under this bill may be nonprofit organizations. A deduction for a charitable contribution is available only to taxpayers who itemize their deductions on Schedule A. Because of the increased standard deduction and changes to itemized deductions discussed above, the number of individuals filing Schedule A is expected to decline from roughly 30 percent to somewhere in the range of 5-10 percent. Charitable giving will certainly continue if this bill is passed, but without the encouragement of a tax incentive, both during life and at death, it is likely that the overall level of giving will decline.
*On November 9, the Senate Finance Committee released its 253-page version of the Tax Cuts and Jobs Act bill and the House Ways and Means Committee approved its version of the bill on a party line vote. There are several similarities between the two bills, such as reducing the top corporate tax bracket to 20 percent and the repeal of the alternative minimum tax, but there are also many important differences, such as maintaining seven tax brackets for individuals, preserving the itemized deduction for medical expenses, and preserving the federal estate tax, though at the higher exclusion amounts described above.
DISCLAIMER: The foregoing does not constitute legal advice and has been prepared for informational purposes only. Please contact us directly with questions about how these and other nonprofit laws and procedures relate to your specific organization.
Prepared by GKH attorney Doug Smith. Attorney Smith practices in the areas of Estate Planning and Administration, Business Succession Planning, Nonprofit Organization, Corporate and Commercial Law, and Tax Law.