Editor’s Note: This is the third in a three-article series on the new federal tax law. The other articles are as follows:
- The Tax Cuts & Jobs Act: What It Means for Businesses
- The Tax Cuts & Jobs Act: What It Means for Pass-Through Entities
- The Tax Cuts & Jobs Act: What It Means for Individuals
On December 22, 2017, President Donald Trump signed the “Tax Cuts and Jobs Act” into law, marking one of the most dramatic transformations in the history of the modern tax code. Designed to spur investment and economic growth, the law is at the same time simple in concept and yet extremely complex in execution.
With that in mind, it is imperative for small business owners and individual taxpayers alike to become familiar with the law and its provisions as they impact both business and individual tax strategies. In this three-part series, we are examining some of the key policy highlights that business owners should be aware of as they plan for the future.
In the first two articles of this series, we examined the impact of the new tax law on businesses as a whole, and then specifically on pass-through entities such as LLCs, “S” corporations, partnerships and sole proprietorships. In this article, we will zero in on the impact of the new tax law on individual taxpayers, including business owners and non-business owners alike.
The Graduated Income Tax
As we begin, it is important to understand that the United States employs a graduated income tax system, which means that not all of the taxpayer’s income is taxed at the same rate. In other words, just because you may be a high income earner and therefore fall into a higher tax bracket, it is not all of your income that is taxed at the higher rate, but rather just the amount that exceeds your eligibility for prior brackets (referred to as the marginal income, i.e. the amount that exceeds the margin set for the prior bracket).
For individual taxpayers, the new brackets are organized into seven levels, which provide graduated rates from 10% up to 37%. There are four distinct sets of income brackets, depending upon the taxpayer’s filing status. They are:
- Married individuals filing joint returns, and surviving spouses
- Single individuals (other than heads of households and surviving spouses)
- Heads of households (who are not married and filing a joint return)
- Married individuals who are filing separately
For the purposes of this article, we will focus on the first set, which is applicable to married individuals filing joint returns, and surviving spouses. For taxpayers in this category, the brackets are as follows:
Taxable Income Amount >> Tax
- Up to $19,050 >> 10%
- Over $19,050 up to $77,400 >> 12%
- Over $77,400 up to $165,000 >> 22%
- Over $165,000 up to $315,000 >> 24%
- Over $315,000 up to $400,000 >> 32%
- Over $400,000 up to $600,000 >> 35%
- Over $600,000 >> 37%
What this means is that if you earned $200,000 in taxable income as a married couple filing jointly, your income tax would be calculated as follows:
$1,905 (10% of the first $19,050) +
$7,002 (12% of the amount from $19,050 up to $77,400) +
$19,272 (22% of the amount from $77,400 up to $165,000) +
$8,400 (24% of the amount from $165,000 up to $200,000) =————————————————————————————————————
It is important to note that these figures apply to the taxpayer’s total taxable income, which consists of the taxpayer’s Adjusted Gross Income (AGI), minus allowances of personal exemptions and deductions.
With this in mind, we now need to turn our attention to the most valuable component for many business owners and high-earning individuals, the use of tax deductions. On a nationwide basis, approximately 30% of taxpayers choose to file with itemized deductions on their federal tax returns, and the remainder rely on standard deductions.
We will begin with the standard deductions. Taxpayers are allowed to reduce the Adjusted Gross Income (AGI) that they use by the amount of the standard deduction, or by the sum of all itemized deductions they wish to declare, in order to determine their taxable income.
The new law increases standard deductions from the prior levels and applies the higher standard deductions for the tax years between December 31, 2017 up through December 31, 2025. During these tax years, the standard deductions are now as follows:
- $24,000 for married individuals filing a joint return
- $18,000 for heads of households
- $12,000 for all other taxpayers
These figures are also set to be adjusted for inflation in the tax years beginning after 2018, and the new law makes no changes to additional standard deductions previously established for the elderly and the blind.
At the same time, the prior provision for personal exemptions that could also be subtracted from Adjusted Gross Income by the taxpayer, the taxpayer’s spouse and any dependents (as applicable), has been suspended by the allowed exemption amount being set to zero. There are certain exceptions to this change applied to qualified disability trusts and other previously established special categories, so if you believe you may be eligible for one of these categories, speak with your CPA to ensure that any potential exceptions to the zeroing-out of the personal exemption rule can be addressed.
Taxpayers who have previously or might in the future desire to claim an itemized deduction for an uncompensated personal casualty loss (such as a fire, storm, theft or other event) will no longer be able to do so under the new law, except where such losses were incurred in a Federally-declared disaster. At the same time, taxpayers may want to avail themselves of an increase in the charitable deduction contribution limitation, which has been raised from maximum of 50% to a new maximum of 60%.
Dependent Children and Itemized Deductions
For taxpayers with dependent children, it is notable that the new law makes changes to the provisions commonly known as the “kiddie tax”, i.e. the provisions addressing the net unearned income of a dependent child. Previously, such income was taxed at the parents’ rates if the parents’ tax rates were higher than those the child would be subject to, with the remainder of the child’s taxable income taxed at the child’s own applicable rates. Going forward under the new law, the child’s earned income is now taxed under the rates for single individuals, with the child’s unearned income taxed at the rates applicable to trusts and estates, instead.
While we’re talking about children, it is notable that the child tax credit was increased under the new law from $1,000 per child under 17 under the prior law, to $2,000 per child under 17 now, with a $500 nonrefundable credit provided for certain non-child dependents. The income level at which the credit phases out has been increased to $400,000 for married taxpayers filing jointly, and $100,000 for all other taxpayers, and it is not indexed to inflation.
At the same time, the new law suspends or reduces some of the most popular deductions, the most notable among them being the mortgage and home equity interest deductions. Previously, taxpayers could deduct as an itemized deduction the interest associated with a mortgage on the taxpayer’s principal or second residence, with a value up to $1 million for married filing jointly or $500,000 for married filing separately, and home equity indebtedness up to $100,000. Under the new law, the deduction for interest on home equity indebtedness is fully suspended, while the deduction for mortgage interest is limited to underlying indebtedness up to $750,000 for married filing jointly, and $375,000 for married filing separately.
In addition, the medical expense deduction threshold is temporarily reduced under the new law from a previous level of 10% of Adjusted Gross Income (AGI) down to 7.5% of AGI going forward. Also suspended is the alimony deduction by divorced persons acting as payer, or the inclusion of such income by the payee. Also eliminated is the miscellaneous itemized deductions options that would apply when such deductions, in aggregate, would exceed 20% of the taxpayer’s Adjusted Gross Income (AGI).
Capital Gains and Carried Interest
Taxpayers who report capital gains or carried interest will also face some adjustments under the new law. For individual taxpayers, any adjusted net capital gain is taxed at maximum rates of 0%, 15% or 20%, each with a specific breakpoint. Under the new law, the standard maximum rates on net capital gains and qualified dividends remain in place, and the breakpoints remain in place but will now be indexed for inflation using the C-CPI-U, rather than the CPI-U (see discussion below for an explanation of the difference).
In addition, changes in the holding period requirement for carried interest could impact individual taxpayers if they are members of a partnership. Generally speaking, the receipt of a capital interest for services provided to a partnership results in taxable compensation for the recipient, except in the case where the receipt of the profits interest in exchange for services provided entitles the holder to share only in gains and profits going forward (this is under a safe harbor rule).
Under prior law, such carried interests were taxed at the taxpayer level using favorable capital gain rates, rather than as ordinary income. Going forward, the law imposes a three year holding period requirement in order for such applicable funds to be tax as a capital gain, otherwise it will be taxed as short-term gain at ordinary income rates.
Deductions for State and Local Taxes
One of the biggest changes that the new law made is to significantly limit state and local tax deductions. For residents of higher-tax states, this change may make an outsized impact, since most state and local taxes (such as real estate property taxes, personal property taxes, state income taxes and/or sales taxes) could previously be deducted in full, in most cases.
Under the new law, taxpayers may only deduct up to $10,000 (or $5,000 for a married taxpayer filing a separate return) as an itemized deduction, and this amount is only deductible in cases where the applicable taxes are not being paid or accrued as part of a business activity (what the IRS code officially refers to as “carrying on a trade or business,” or “an activity for the production of income.
Note: For more information on the role of this provision, please see the second article in this series, “The Tax Cuts & Jobs Act: What It Means for Pass-Through Entities”, which addresses the tax law’s impact on taxpayers who own “S” corporations, LLCs, partnerships or sole proprietorships, and therefore pass business income through to their individual income tax returns.
In addition, the law contains a prepayment provision which indicates that a taxpayer who, in 2017, pays a state or local income tax that is imposed for a tax year after 2017, the taxpayer in question may not claim an itemized deduction in 2017 for that prepaid income tax.
These two stipulations have caused a serious uproar among taxpayers and elected officials in states who have high state and/or local tax burdens. In the Mid-Atlantic region, this is generally recognized to include New York, New Jersey, Maryland and the District of Columbia. While legislators in these and other high tax burden jurisdictions have openly discussed a variety of strategies for adjusting state laws to work around this change in policy, at the moment the cold, hard reality remains that affected taxpayers will be forced to dramatically adjust to this new federal policy.
Changing the Inflation Measure to Chained CPI
One important point that impacts multiple provisions across the new law is the change in the measure of inflation used in sections such as tax brackets, standard deductions, personal exemptions and other figures that are subject to ongoing inflation-related adjustments.
Under the law, the inflation measure has been changed from the CPI-U (Consumer Price Index) to the chained CPI-U or C-CPI-U, which will generally grow at a slower pace because chained CPI takes into account the ability of consumers to substitute one good for another when relative prices go up.
Repeal of the ACA Individual Mandate
Finally, it is worth noting that the individual mandate under the Affordable Care Act (ACA) was indeed repealed under the new tax law, by way of an amendment that sets the “shared responsibility payment” (i.e. the individual mandate penalty payment) at zero.
The highlights shared in this article are just a summary of key points in the law. Remember that the actual law itself is 1,097 pages in length, and contains numerous provisions and adjustments that could impact your small business, and you as a small business owner or as an individual taxpayer. Make sure to meet with your CPA or tax preparer proactively to review the impact of the new in detail, and prepare to adjust and update your tax strategy accordingly.