Tax Reform: Changes to Business Loss and Net Operating Loss Deductions

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the third of a series of articles reviewing some of the more important changes.  This post deals with changes to the deduction of nonpassive business losses and to net operating losses.

Current Year Excess Aggregate Net Business Losses

Excess aggregate net business losses of individuals and trusts/estates are not allowed for the year of loss.  This is a significant but not well publicized change for those who are impacted.  The excess business loss limitation sunsets after 2025.

·      An excess business loss is the amount over $500,000 MFJ or $250,000 for other individuals and trusts/estates.  Thus, other income such as wages or portfolio income cannot be sheltered from income tax to the extent of the excess loss.

·      The excess loss is treated as a NOL carryforward even if the taxpayer doesn’t otherwise have an actual NOL for the year.  Treating excess losses as part of a NOL limits the future deduction to 80% of taxable income.  See discussion below.

·      Business losses can arise from a sole proprietorship, a partnership, or an S corporation.  The determination is made at the partner and S corporation shareholder level.

·      The excess business loss is a new, fourth loss limitation rule:  1) tax basis, 2) at-risk basis §465, 3) passive activity loss §469, and 4) excess business loss §461(l).

Net Operating Losses

NOLs generated in tax years beginning after 2017 may only be carried forward and not carried back to earlier tax years to get a tax refund.  An exception is provided for certain farm losses.  The NOL changes are permanent and do not sunset.

·      Post-2017 generated NOLs will have an indefinite carryover period instead of the current 20-year carryover period.

·      However, post-2017 generated NOLs may only offset 80% of taxable income.

·      Pre-2018 NOLs are grandfathered and can offset 100% of taxable income and can also be carried back.  Therefore, depending upon facts and circumstances, it may be good tax planning to make the 2017 NOL as high as possible.

Tax Reform: Changes to the Standard Deduction, Exemptions, and Itemized Deductions

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the second of a series of articles reviewing some of the more important changes.  This post deals with changes to the standard deduction, personal exemptions, and itemized deductions.  Unless otherwise specified, these changes start in tax years beginning after 2017 and sunset after 2025.

Standard Deduction

The standard deduction increases from $13,000 in 2018 to $24,000 for married filing joint returns, from $6,500 to $12,000 for single taxpayers, and from $9,550 to $18,000 for head of household.  It is estimated that the percentage of taxpayers itemizing deductions will decline from 40 million to 9 million because of the increase in the standard deduction.  The additional standard deduction for the elderly and the blind is retained.

Personal Exemption

The personal exemption of $4,150 in 2018 is repealed as well as the rule phasing out the personal exemption when AGI exceeds a certain threshold (e.g., $320,000 MFJ).  However, the $100/$300/$600 personal exemptions of trusts and estates are not repealed.

Medical Itemized Deduction

The medical deduction is retained.  A favorable change was made retroactively for 2017 and for 2018.  The AGI percentage threshold that must be reached before medical expenses become deductible is lowered from 10% to 7.5%.  The percentage threshold reverts to 10% after 2018.

State and Local Tax (SALT) Itemized Deduction

The sum of state and local income or sales tax plus real and personal property tax is limited to $10,000 for MFJ, singles, and trusts and estates.

·      Real and personal property and sales taxes attributable to businesses reported on Schedules C, E, or F are deductible on those schedules and are not repealed or limited.

·      But individual income taxes attributable to business profits reported C, E, or F are considered itemized deductions and are subject to the $10,000 cap.

·      Foreign income taxes may be deducted without regard to the limit if they are not claimed as a credit.

·      However, foreign real property tax is no longer deductible unless it is incurred in a business.

·      Generation skipping transfer tax paid on a taxable trust distribution is not limited.

·      The new tax law specifically states that no 2017 deduction is permitted for prepaying 2018 state income tax.  What about excess 2017 prepayments applied to 2018 state tax?  Typically, refunds of overpaid state estimated taxes are taxable in the year of receipt if a tax benefit was received from the deduction.  Will this continue to be the rule?

·      Prepayments in 2017 of 2018 real estate tax was not specifically prohibited, but the IRS issued an advisory (IR-2017-2010) stating that the deduction would not be allowed if assessment of the tax did not occur before 2018.

·      The $10,000 tax deduction limit applies to both singles and MFJ, a marriage penalty.  This makes it harder for a MFJ couple to benefit from itemizing their remaining deductions because of the higher MFJ standard deduction.

·      There is no real impact of the $10,000 SALT limit for taxpayers subject to the AMT under old law.

·      If making gifts in trust for children, consider setting up separate trusts for each child beneficiary to get multiple $10,000 SALT limits instead of using a single trust for all the children.

Interest Itemized Deduction

Interest paid on total mortgages not exceeding $750,000 for debt incurred after 12/15/2017 is deductible for principal and/or secondary residences.  Refinancing of mortgages incurred on or before 12/15/17 is treated as incurred on the same date of the original debt (meaning the old $1 million limitation continues to apply).

·      Written binding contracts entered into before 12/15/2017 to purchase a principal residence before 1/1/2018, where the home is actually purchased before 4/1/2018, can still use $1 million limit.

·      Home equity loan interest after 2017 is not deductible with no grandfathering of existing loans.

·      Consider the “interest tracing” rules to preserve the home equity loan interest deduction if the loan was used to improve the home or used to acquire an investment.

·      The investment interest expense deduction is retained.

·      The mortgage insurance premium deduction expired at the end of 2016 and was not renewed.

·      Pay off non-deductible home equity debt.  Re-borrow it later to invest in a business or other investment.

Charitable Contribution Itemized Deduction

Charitable contributions are still allowed as itemized deductions.  However, with the increase in the standard deduction and with the $10,000 SALT limitation, the number of taxpayers benefiting from itemizing charitable donations is expected to fall significantly, particularly so for those who have no home mortgage interest expense.

·      The charitable contribution deduction is limited to a percentage of adjusted gross income for individuals.  The new law increases the limitation to 60% of AGI (from 50%) for cash donations made to public charities.

·      A carryover of unused pre-2018 cash contributions would continue to be limited to 50% of AGI.

·      No change was made to the 30% and 20% of AGI limitations for the donation of long-term appreciated property.

·      The 5-year carryover of excess contributions is retained.

·      However, the 80% deduction for contributions to obtain rights to purchase college athletic event seating is repealed.

·      Taxpayers age 70 ½ or older with traditional IRAs can make a direct charitable gift to a public charity (but not to a DAF) of up to $100,000 out of the IRA to get around the higher standard deduction and satisfy their RMD.

Casualty and Theft Loss Itemized Deduction

The casualty and theft loss itemized deductions are repealed except for casualty losses in presidentially declared disaster areas.

Miscellaneous Itemized Deductions Subject to the 2% of AGI Floor

The deduction of miscellaneous itemized expenses subject to the 2% AGI floor is repealed.  Examples of these types of expenses include:  tax preparation fees, home office, license fees, professional dues and subscriptions, legal fees for tax advice, unreimbursed employee business expenses, job hunting costs, investment management and advice, hobby loss expenses, and excess expenses upon a termination of a trust or an estate.

Miscellaneous deductions not subject to the 2% AGI floor are retained.  These include gambling losses to the extent of winnings and the deduction for estate tax paid on items of income in respect to a decedent (IRD).  Trusts and estates must distinguish administrative expenses not subject to the 2% floor from miscellaneous itemized deductions that are subject to the floor and therefore no longer deductible.

“Pease” Limitation on Itemized Deductions

Prior law required a reduction to the amount of the itemized deduction when a taxpayer’s AGI exceeded a certain threshold.  The reduction was generally 3% of the amount of AGI in excess of the threshold.  This provision was in effect a hidden 1.2% tax rate and was often referred to as the “Pease” limitation, named after the Senator who proposed the provision.  This limitation is repealed.

“Bunching Itemized Deductions”

If necessary, “bunch” remaining deductible itemized deductions into every other year to get over the increased standard deduction hurdle.  For example, if you bunched your 2018 itemized deductions into 2017 (e.g. by prepaying 2017 SALT and donations), then bunch your 2019, 2020, & 2021 itemized deductions into 2020.

Tax Reform: Individual Income Tax Rate Cuts

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date).  The legislation is massive, running 1,097 pages with committee reports.  Congress authorized the Treasury Department to write “legislative” regulations, so the law won’t be settled for years to come.  Further, a technical corrections bill is expected.  Every individual and business will be impacted and whether you win or lose depends on your circumstances:  where you live, how you earn income, and the form of your business entity.  The business tax cuts are generally “permanent” but the individual tax cuts are temporary, sunsetting after 2025.  The massive number of changes, the temporary nature of many of the significant changes, and the risk of change in future political power bring a real sense of disruption and uncertainty.  Long-standing tax laws, to which people have organized their businesses and personal lives, have changed and will likely change again in the next eight years.  Generalizations will be dangerous.  Professional advisors will need to “unlearn” the old ways of planning and embrace the challenge of learning how to plan in the new landscape of “tax reform.”

Because so many tax laws have changed, I will be posting a series of articles reviewing some of the more important changes.  This first post deals with individual income tax rate cuts.

Married Filing Joint, Ordinary Income Tax Rates—2018

Prior Law		New Law
$19,050	10%	$19,050	10%
$77,400	15%	$77,400	12%
$156,150	25%	$165,000	22%
$237,950	28%	$315,000	24%
$424,950	33%	$400,000	32%
$480,050	35%	$600,000	35%
$480,051+	39.6%	$600,001+	37%

Single, Ordinary Income Tax Rates—2018

Prior Law		New Law
$9,525	10%	$9,525	10%
$38,700	15%	$38,700	12%
$93,700	25%	$82,500	22%
$195,450	28%	$157,500	24%
$424,950	33%	$200,000	32%
$426,700	35%	$500,000	35%
$426,701+	39.6%	$500,001+	37%

Trust/Estate, Ordinary Income Tax Rates—2018

Current Law		New Law
$2,600	15%	$2,550	10%
$6,100	25%
$9,300	28%	$9,150	24%
$12,700	33%	$12,500	35%
$12,701+	39.6%	$12,501+	37%

Long-Term Capital Gain and Qualified Dividend Tax Rates—2018

Rate	MFJ	Single	Trust/Estate
0%	$77,200	$38,600	$2,600
15%	$479,000	$425,800	$12,700
20%	$479,001+	$425,801+	$12,701+

Observations Regarding the New Tax Rates

·      The lowered tax rates are effective only for tax years beginning in 2018 through 2025 after which the prior law rates return.

·      The reduced top rate is still higher than the 2012 tax rate of 35%.

·      There is a sweet spot between $165,000 and $315,000 of MFJ taxable income where the tax rate is significantly reduced.

·      There is no “marriage penalty” for the first 5 rate brackets.  Previously this was true only for the first 2 brackets.

·      Although not shown, the head of household brackets vs. single brackets are better only for the first three instead of all seven brackets as was the case previously.

·      The brackets are indexed by the slower link-chained inflation method (C-CPI-U vs CPI-U) where the consumer is assumed to be able to substitute cheaper products in response to increased prices.  The new method does not sunset.

·      With rates scheduled to increase after 2025, Roth retirement account contributions should be considered before then.

·      Tax savings should be invested for retirement as increasing deficits will likely affect Social Security and Medicare benefits for the upper middle class.

·      Although estates and electing trusts can use a fiscal year to defer income tax, most should think about a calendar year for the lower tax rates.

·      The preferential long-term capital gain and qualified dividend tax rates are no longer linked to the ordinary tax rate brackets.

·      The 3.8% net investment income tax under the Affordable Care Act remains and applies when modified adjusted gross income exceeds:  $250,000 MFJ; $200,000 single; and $12,500 trusts and estates

“Kiddie Tax” Simplified

The current nightmare of preparing income tax returns of children under age 19 (24 if a full-time student) is simplified.  Instead of using the parents’ tax rates, and lumping siblings together, a child’s unearned income is taxed using the trust and estate tax rate brackets for both ordinary and capital gain rates for unearned income.  The child’s earned income is taxed under the rates for single individuals.  However, simplification comes at a cost for families not in the highest income tax bracket because the top trust ordinary and capital gain tax rates are reached at only $12,500 of taxable income.

Individual Alternative Minimum Tax Retained

Surprisingly, the AMT was retained at the last minute as part of the horse trading to secure votes from key senators.  Repealing the AMT would have been a great simplification to the law and it is disappointing to see that it remains.  The exemption from AMT was increased slightly but the exemption phase-out threshold was dramatically increased.  For MFJ, the exemption is increased from $86,200 to $109,400 with phaseout starting at $1,000,000 up from $164,100.  For a single, the exemption is increased from $55,400 to $70,300 with phaseout starting at $500,000 up from $123,100.  The $24,600 exemption for an estate or trust is not changed and the phase-out continues to start at $82,050.

Observations Regarding the AMT

Those paying 2017 AMT may find their marginal tax rates increasing in 2018 when AMT is less likely to apply.  For example, at $500,000 of taxable income the rate would increase from the 28% AMT rate to the 35% regular tax rate.  With the dramatic changes to itemized deductions, AMT will be less likely to apply, although it will continue to apply in a couple of circumstances.  First, those exercising and holding incentive stock option stock will continue to risk incurring the AMT.  Second, because regular tax rates were cut but AMT tax rates were not cut, it is possible upper middle-class taxpayers will continue to be subject to the AMT, but at a higher income level.  As generalizations are dangerous, it is important to run tax projection calculations to determine how the AMT may apply to taxpayers in the future.

Last Minute Tax Planning Now that “Tax Reform” is Enacted

The House and Senate approved the Tax Cuts and Jobs Act bill December 20, 2017.  The President signed it December 22, 2017.  The tax bill is massive, weighing in at 1,097 pages including the Conference Committee report.  It will take some time to digest all the changes, but every taxpayer and business is affected.  What can you do right now to cut your taxes?

Accelerate Deductions

Deductions save more taxes when tax rates are high.  Since overall tax rates will decline in 2018, it may make sense to prepay some expenses by December 29^th, such as paying your January 2018 home mortgage payment early, advance funding your 2018 charitable giving, prepaying any 2017 state income taxes that would otherwise be due as an estimated tax payment in January or would be due with your tax return, and harvesting any capital losses in your investment portfolio.  Check your individual circumstances.  If your income will be higher in 2018, you might be in a higher tax bracket next year.  Note that prepaying in 2017 your 2018 state income tax will not be deductible according to the Conference Committee report.  It is uncertain whether prepaying your 2018 real estate tax will be deductible, but the report did not expressly prohibit it. On December 27, 2017, the IRS released an advisory that "A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017."

The standard deduction will be increased in 2018 to $24,000 for joint tax returns and $12,000 for singles.  If your total itemized deductions approximate these amounts, you may wish to “bunch” your deductions into every other year to more efficiently use your deductions.  For example, you may wish to bunch deductions into 2017 and then again in every odd numbered year.

Delay Income

Send invoices late in the month to avoid receipt in December, defer deliveries of merchandise to customers, and work with your employer to postpone receipt of a bonus while avoiding constructive receipt.  Postpone converting a traditional IRA to a Roth IRA until 2018.  Delaying income to 2018 may allow it to be taxed at lower tax rates.  Again, you must look at both 2017 and 2018 taxes to know the right course of action for your situation.

Roth IRA Recharacterizations

The ability to recharacterize a Roth IRA conversion is repealed after 2017.  If you have already converted a traditional IRA to a Roth IRA during 2018, you may wish to consider unwinding the conversion by a recharacterization by December 29^th in a couple of circumstances.  First, if the value of the account has declined from the value at the time of conversion, recharacterize so that you don’t pay tax on value that no longer exists.  Second, if the account hasn’t appreciated too much, consider recharacterizing now and reconverting in early 2018 if your tax rate on the reconversion will be less than your 2017 tax rate on the original conversion.

If Subject to 2017 Alternative Minimum Tax

If you are subject to AMT in 2017, and the amount of the AMT exemption has been fully phased out due to high income, then you are subject to an effective 28% Federal tax rate.  Since the impact of the individual AMT is greatly reduced in 2018 and likely not to apply, you might find that your marginal 2018 tax rate is greater than 28%.  In such a case, you should consider exercising nonqualified stock options, accelerating bonuses, or converting a traditional IRA to a Roth IRA before the end of 2017.  In addition, you should consider deferring charitable deductions to 2018.  Incentive stock options should be exercised in 2018 when the AMT is much less likely to apply to the AMT ISO preference.

Business Equipment

If you are planning to purchase business equipment in 2018, consider purchasing and placing in service the equipment before the end of 2017.  Bonus depreciation is increased to 100% for equipment and machinery purchased and placed in service after September 27, 2017.  Taking bonus depreciation in 2017 when tax rates are high will likely save more taxes than if done in 2018.

Year-End Tax Planning in Conditions of Uncertainty

With December 31, 2017 fast approaching, and with the “sausage-making” going on in Congress with respect to so-called “tax reform,” it is difficult to know what to rely upon when considering year-end tax planning.  This past week the House of Representatives passed their version of tax reform and the Senate Finance Committee approved their plan.  The full Senate will take up their plan after Thanksgiving.  If the Senate approves a plan, then the differences between the House and Senate bills will have to be reconciled with the resulting bill subject to approval by the two chambers once again.  All this is to be done before Christmas so that the president can sign the legislation before year end.

So what tax-planning steps should you consider now?  If you wait to start planning until after seeing whether tax reform is enacted, you may find yourself without sufficient time to determine and execute strategies during the busy year-end holiday season.  Many changes are proposed, and every taxpayer will be affected.  The changes are so many that there will be interplay between provisions, and taxpayers having similar total income will be treated very differently depending upon their individual circumstances.  Here are some general considerations, but you should undertake a detailed tax projection calculation to confirm whether any of these suggestions could be beneficial to you.  Undertaking “scenario planning” will help you be ready to act by year-end.

1.      After 2017, the top individual ordinary income tax rate remains 39.6% in the House bill but is cut to 38.5% in the Senate bill.

a.      Defer income to 2018 and accelerate deductions to 2017.

b.     If you are not in the top bracket, then you should examine the proposed tax rate brackets to see what your tax rate may become after 2017.

2.      After 2017, many itemized deductions are repealed.  The House bill will only allow a real property tax deduction of up to $10,000 on your principal residence, mortgage interest on up to $500,000 of acquisition debt (with pre-November 2, 2017 debt grandfathered) on your principal residence, and charitable contributions.  The Senate bill will not permit any tax deductions, but allows medical, mortgage interest on up to $1,000,000 of acquisition debt on your principal residence, and charitable contributions.

a.      Pay your real estate tax and state income taxes in 2017.

b.     Pay down home equity borrowings as that interest won’t be deductible after 2017 if the use of the borrowings cannot be traced to expenditures for home improvements or for the purchase of business or investment property that would still permit deductible interest.

c.      If your total itemized deductions approximate the proposed increased standard deduction of approximately $24,000 for joint filers, or $12,000 for singles, then you should “bunch” your deductions into every other year, beginning with 2017.

3.      After 2017, the alternative minimum tax is repealed.

a.      Defer exercising incentive stock options until after 2017 to avoid AMT.

4.      After 2017, a recharacterization of a Roth IRA conversion will not be permitted.  Under current law, recharacterization is permitted until October 15^th of the year following the year of conversion, giving a generous window of time to unwind the conversion if the value of the account falls below the amount of conversion income.

a.      Examine your 2017 conversions of traditional IRAs to Roth IRAs to see if the value of the account has dropped and make the recharacterization before the end of 2017 if necessary.

5.      After 2017, the Senate bill would require the use of “first-in first-out” identification of basis in securities for determining gain or loss, repealing the “specific identification” method.  It appears that the change might also encompass in-kind charitable contributions and gifts.

a.      Use the specific identification method for choosing the specific lots of securities to sell or to donate before 2018.  For example, choose high basis securities when selling and choose low basis securities when donating to charity.

6.      After 2017, tax-deferred, like-kind exchanges will be limited to real property.

a.      Enter into any non-real estate exchanges before the end of 2017.

7.      After 2017, partnership, S-corporation, and sole proprietorship net business income will be taxed less.  The House bill uses a 25% tax rate on passive business income and on 30% of nonpassive business income.  The House bill also has a 9% tax rate for very small businesses.  The Senate simply uses a 17.4% deduction.  The reduced tax will not apply to professional service business income.

a.      Defer business income to 2018 and accelerate deductions to 2017 to boost the amount of net business income subject to the lower tax.

b.     Fiscal year pass-through businesses should consider changing their tax year to a calendar year to gain advantage of the lower tax rates sooner, permanently saving tax.

8.      The C corporation income tax rate will be lowered to 20% for tax years beginning after 2017 in the House bill or after 2018 in the Senate bill.

a.      Again, defer income and accelerate deductions.

b.     If starting a new business, carefully consider whether a C corporation entity might be a better choice than a tax partnership or S corporation.