The Tax Cuts and Jobs Act ....
is the most sweeping update to the U.S. tax code in more than 30 years. The reforms will simplify taxpaying for many individual Americans, lower taxes on individuals and businesses, and update the business tax code so that American corporations and the people they employ can be globally competitive again.
The Tax Cuts and Jobs Act has the potential to unleash higher wages, more jobs, and untold opportunity through a larger and more dynamic economy. The bill’s pro-growth components include a deep reduction in the corporate tax rate, a scaled-back state and local tax deduction, full (albeit temporary) expensing, and lower individual tax rates. The bill also repeals Obamacare’s individual mandate, expands college savings accounts, and increases some non–growth-enhancing tax credits and deductions.
The conference report demonstrates a serious effort to reform a complex and badly broken system that provides significant relief to the vast majority of taxpaying Americans. While Congress surrendered to the pressures of special interests in several areas, eroding many of the boldest components of their original proposals, the conference agreement nevertheless reflects a critical step in the right direction.
Business Tax Reform
The Tax Cuts and Jobs Act’s most significant changes are to modernize the tax treatment of businesses in the United States. Taken together, the business reforms will result in a significant boost to the U.S. economy by attracting international business investment and jobs to America.
Previous analysis of the two similar bills, independently passed by the House and the Senate, estimates that the economy could grow between 2.6 percent and 2.8 percent larger in the long run.
21 Percent Corporate Rate. The bill permanently lowers the corporate tax rate to 21 percent starting in 2018. This is a flat rate. No longer progressive rates of 15, 25, 34, 35%.
Historically, U.S. businesses have faced some of the highest statutory corporate tax rates in the developed world.
A 21 percent corporate tax rate, down from the current federal rate of 35 percent, is the most pro-growth component of the Tax Cuts and Jobs Act. The reform will encourage significant new investment in the U.S., which will benefit workers primarily through higher wages and more jobs.
A 21 percent federal corporate tax rate still leaves the United States with a higher rate than many of its largest trading partners around the world. When average state taxes are added, the U.S. will have a cumulative rate around 26 percent—higher than the worldwide average of 23 percent.
Bonus Depreciation = Full Write-Off. The bill expands the current-law 50 percent bonus depreciation for new short-lived capital investments to 100 percent or “full expensing” for five years and then phases out over the subsequent five years. Expensing allows companies to deduct the cost of investments (new & used) immediately and removes a current tax bias against investment.
The bill also expands expensing for small businesses under Section 179 by raising the cap on eligible investment from $500,000 to $1 million. The phaseout increases from a $2 million cap to a $2.5 million cap on total equipment purchases. In 2022, businesses will no longer be able expense their research and development costs; this is a step in the wrong direction toward longer write-off schedules rather than toward expensing.
20 Percent Pass-Through Deduction. Small and pass-through businesses that pay their taxes as individuals (and face the new lower individual tax rates) will receive a newly created deduction. Pass-through businesses will be able to deduct 20 percent of certain types of non-salary business income, bringing the top marginal tax rate (on most pass-through income) down from 39.6 percent under current law to 29.6 percent. This 20% deduction also applies to sole proprietorships. Certain service providers in the fields of health, law, consulting, athletics, financial, or brokerage services are denied the deduction if their income is over a $315,000 threshold, where the deduction begins to phase out.
Although lower marginal tax rates for small and pass-through businesses are an important component of economic growth, the discrepancy in top rates between individual income and small and pass-through business income will increase the incentives to treat income from wages artificially as business income. This new tax privilege has no consistent policy rationale, arbitrarily favors certain types of businesses over others, introduces new complexity, and will provide new opportunities for unproductive tax planning.
- Example 1: Jack, a single taxpayer, has a “regular” job where he earns a $100,000 salary as an employee. He also “moonlights” as a consultant and earns $50,000 of net profit via his Schedule C sole proprietorship. Now suppose that after accounting for deductions for self-employment taxes and the standard deduction, Jack’s taxable income is $133,500 (before application of the pass-through deduction). Here, Jack’s business income of $50,000 is less than his taxable income of $133,500. As a result, the 20% pass-through deduction will be applied to Jack’s $50,000 of business income, resulting in a $10,000 ($50,000 x 20% = $10,000) deduction.
- Example 2: Jill, a single taxpayer, is a real estate agent who earns $100,000 of net profit via her Schedule C sole proprietorship. This is Jill’s only source of income. After factoring in Jill’s deductions for self-employment taxes and the standard deduction, her taxable income is $73,000 (before application of the pass-through deduction).
Contrary to our first example, here, Jill’s taxable income of $73,000 is less than her eligible business income of $100,000. Therefore, Jill’s 20% pass-through deduction will be applied to her $73,000 of taxable income. This results in a $14,600 (73,000 x 20% = $14,600) deduction.
The act imposes a new onetime transition tax on international firm’s accumulated overseas profits. The onetime tax rate is 15.5 percent for liquid assets and 8 percent for physical assets.
Limited Interest Deduction. The current unlimited deduction for net interest expense for C-corporations is capped at 30 percent of earnings before interest and taxes. For the first four years, the cap applies to a slightly different definition of earnings before interest, taxes, depreciation, and amortization. This only applies to businesses with receipts exceeding 25 million annually.
For a vast majority of Americans, the Tax Cuts and Jobs Act will lower their federal tax bill in 2018. This is accomplished through lower tax rates, a larger standard deduction, and an expanded child tax credit. Most of the individual tax changes revert to current law before 2025 to meet political constraints and Senate budget rules. Although temporary tax policy is never ideal, the expirations give Congress an incentive to revisit the tax code in the coming years to provide more far-reaching and permanent reform.
Lower Individual Tax Rates. The framework lowers rates for almost every tax bracket. The current seven brackets remain, but with new, generally higher income thresholds and lower rates. Table 1 describes the changes for single and married filers; the bill also retains the head of household status with similar adjustments to income brackets.
Larger Standard Deduction. The standard deduction is almost doubled, consolidating the additional standard deduction and personal exemptions into one larger deduction. For married joint filers, the deduction will be $24,000; for single filers, it will be $12,000. The expanded deduction simplifies tax filing by cutting the percentage of tax filers who will need to itemize their deductions in half. Approximately 9 of 10 taxpayers will simply claim the new standard deduction.
The change will also exempt more people from paying any income tax at all. When fewer people pay income taxes, the harmful side effect is that government appears to cost less for those taxpayers. Decreasing the number of households that pay any federal income tax at all lowers their personal cost of future government expansions, which could lead to higher overall tax rates in the future.
$2,000 Child Tax Credit. The child tax credit (CTC) is doubled from a current-law level of $1,000 to $2,000 per child. The new larger credit begins to phase out for married filers with incomes of more than $400,000—an increase from $110,000 under current law. The new larger credit offsets the repeal of the personal exemption for dependents. For any family in the 25 percent tax bracket or lower, this is an expansion of the tax subsidy for children.
The new larger child tax credit is refundable for taxpayers with no federal income tax liability. This effectively allows a taxpayer to accrue a negative tax liability that results in a federal spending outlay of up to $1,400 per child in 2018. The refundable threshold is indexed to inflation, capping out at the full $2,000 value. A new non-refundable credit of $500 is added for non-child dependent care like care for adult family members with disabilities or elderly parents.
$10,000 State and Local Tax Deduction. Taxpayers who itemize their taxes will be able to deduct up to $10,000 of state and local property taxes and income taxes (or sales taxes) paid. Only about one in 10 taxpayers is expected to itemize deductions under the new tax code.
$750,000 Limit on Mortgage Interest Deduction. The bill does not change the treatment of existing mortgages. Interest paid on up to $750,000 of new home mortgage debt will remain deductible for residences (1st & 2nd) for taxpayers who itemize. The new rules lower the threshold from the current-law level of $1 million and exclude the ability to deduct interest on equity lines of credit. Existing mortgages and lines of credit are grandfathered and protected under the rules existing before the new law.
Charitable Deduction Expanded. The charitable deduction expands for those who itemize, from 50 percent of income to 60 percent. The charitable deduction is denied for payments made in exchange for seats at college sports games.
Other Itemized Deductions Retained. The most politically sensitive itemized deductions and exclusions for medical expenses, tuition compensation, private activity bonds, student loan interest, and teacher spending are all retained. The bill expands the deduction for medical expenses for two years for expenses exceeding 7.5 percent of adjusted gross income, down from the current-law level of 10 percent.
529 College Savings Accounts Expanded. 529 college savings accounts—named after their section of the Internal Revenue Code—are expanded to allow parents to save for K–12 and homeschooling expenses. The reform increases the ability of parents to pay for education options outside the public school system, giving families more education choices.
Individual Mandate Repealed. Obamacare’s individual mandate tax (penalty) is repealed. Zeroing out the tax, which is intended to force individuals to buy health insurance, provides tax relief to millions of Americans who cannot afford the rising costs of Obamacare insurance.
Death Tax Remains. The basic exclusion from the estate tax doubles from its current $5.6 million per person to about $12 million. For married couples, the total would approximate 24 million.
Individual Alternative Minimum Tax Remains. The exemption for the alternative minimum tax (AMT) increases from $86,200 to $109,400 for married filers. The exemption phases out starting at $1 million, up from $164,100. The new exemption is $70,300 for non-married filers and phases out beginning at $500,000.
The AMT applies a two-rate alternative tax schedule to a more broadly defined measure of income and allows a narrower set of deductions. The tax increases the tax liability of those who can uniquely lower their effective tax rate through the normal tax system. The AMT does its intended job poorly and inefficiently by burdening taxpayers with additional paperwork and not addressing the underlying problem: The tax code has too many credits and deductions that are easily gamed. Full repeal of the AMT, as included in the House bill, would have been a far better policy.
PEP and Pease Repealed. The bill rightly repeals two obscure provisions that complicate the tax code and increase effective marginal tax rates. The personal exemption phaseout (PEP) adds more than one percentage point per person to affected taxpayers’ marginal tax rates. For example, it can add 4.5 percentage points to a family of four’s marginal tax rate. The phaseout of itemized deductions (Pease) adds an additional percentage point to affected taxpayers’ marginal tax rates. Repealing these provisions simplifies the code and reduces marginal tax rates.
The U.S. tax code is sorely in need of reform, and the Tax Cuts and Jobs Act is a pro-growth plan that simplifies taxpaying for many individuals, lowers tax rates, and updates the business tax code so that American corporations and the people they employ can be globally competitive again.
Bill Roeser, CPA