On December 22nd the Tax Cut and Jobs Act became law and with it significant changes to how businesses and individuals will be taxed beginning in 2018. Usually when a tax bill passes we try to summarize all of the changes but in this case the changes are more than we can address in a single post, so I will address some of the big items and provide resources if you want to dive deeper.
This tax reform is far from perfect. There are some good features and some bad ones. Below you will find our take on the good, the bad, and the ugly.
Lower Rates: The net result of this tax bill is that most people will see a reduction in their tax liability. Tax rates are coming down across the board and bracket thresholds are moving up.
Standard Deduction: The bill roughly doubles the standard deduction from $12,700 to $24,000 for married couples filing jointly (MFJ). This is likely to reduce the percentage of taxpayers who itemize their deductions from 30% to 8%.
Alternative Minimum Tax: For various reasons (higher thresholds, deductions, and phase outs), less taxpayers will be subject to AMT.
529 Plans: The bill expands the use of 529 college savings plans to include private school tuition for grades K-12, up to $10,000 per year, per student.
Estate Tax: The estate tax exclusion is doubled from roughly 5.5M per person to 11M per person, dramatically reducing the number of families subject to estate taxes.
Child Tax Credit: The partially refundable child tax credit doubles from $1,000 to $2,000 and is available for every dependent child under the age of 17. The law also raises the phaseout threshold dramatically to $400,000 for married couples filing jointly and $240,000 for heads of household.
Corporate Tax Reform: Reform of corporate taxes in the U.S. was long overdue. The U.S. was the only country in the world that taxed profits based on domicile, rather than where profits were earned. This system was laborious, uncompetitive, and easily manipulated. This bill goes a long way towards making the corporate tax system more efficient, levels the playing field between the U.S. and other countries, and provides significant incentives to repatriate profits currently held outside of the U.S.
Corporate Deductions: For the next five years corporations will be able to fully expense capital expenditures rather than depreciating them over time. It is likely that many companies will use this opportunity to increase or accelerate their capital spending which could be advantageous for the economy.
Reduction of Deductions: While the standard deduction has increased significantly, the new law also eliminates or caps many of the itemized deductions taxpayers were used to taking. This includes a cap of $10,000 on any taxes paid on the state and local level, a reduction in the mortgage interest limit, elimination of unreimbursed business expenses, and an elimination of miscellaneous deductions which previously included fees for investment management and tax preparation. Going forward the only folks who are likely to itemize are those who donate significant amounts to charity and/or have a large home mortgage.
Elimination of Personal Exemptions: Previously, there was a roughly $4,000 per person exemption built into the tax code, which has now been eliminated. This elimination is part of the reason the standard deduction was made significantly higher.
Not Everyone Gets a Tax Cut: While rates go down across the board, the changes in deductions are expected to result in a tax increase for approximately 5% of taxpayers.
Repeal of the Affordable Care Act’s Individual Mandate: While Congress was not able to pass a law repealing or reforming Obamacare, they were able to repeal the individual mandate by eliminating the penalty for not having health insurance. The Congressional Budget Office projects that 13 million people will drop their insurance coverage over the next ten years. While the law makes insurance coverage optional beginning in 2019, it does not change the requirement that insurance covers preexisting conditions. This discrepancy and the loss of young, healthy participants could destabilize the insurance market. One potentially positive outcome will be that individuals who are buying their health insurance directly may have more options and potentially lower premiums as insurance companies offer plans that do not meet all the Obamacare requirements.
Tax Cuts are Temporary: Remarkably, most of the individual provisions in this bill expire after 2025. That’s right; after eight years, tax rates and deductions for individuals will go right back to where they were before the law passed. On the other hand, the corporate tax changes are, for the most part, permanent. This expiration is based on weird Senate rules and Republicans are hoping that at some point in the future they’ll be able to vote to make the cuts permanent. In the meantime, this bill creates uncertainty and makes long-term planning increasingly difficult.
Pass Through Tax Deduction: There was much wrangling about if and how pass-through businesses (LLCs, S corps, partnerships, and sole proprietors) should pay less tax. The final version of the bill includes a 20% deduction meaning that only 80% of a pass-through company’s profits would be taxed. Unfortunately, this does not apply to all businesses as it specifically excludes professional service businesses such as doctors, lawyers, accountants, financial advisors, and others. The law specifically includes architects and engineers (who must have had excellent lobbyists) and provides some level of deductions for all business owners with income below a certain threshold ($315,000 for couples). This part of the law creates winners and losers based on industry, employment, and income levels. It is not clear why Republicans would favor lower income sole proprietors, architects, and engineers over large professional firms that employee hundreds of people, but they do. This pass-through deduction could also lead to significant manipulation of the tax code by both businesses and individuals – the last thing you want from tax reform.
This is Not Deficit Neutral: This bill is estimated to add $1.5T to the deficit over ten years. Even if it results in higher growth for the economy, there is still likely to be $1T of extra debt. This must make the fiscal conservatives in the room a bit uncomfortable.
Post Card Promise: There are pictures of Paul Ryan and President Trump holding up postcards and promoting the idea that many people will be able to file their taxes on this small, simplified form. This bill certainly simplifies tax filing for many but it is hard to imagine this will really happen.
This was an opportunity for Republicans to live up to their fiscal conservative mantra and pass a law that made our overly complex tax system simple and efficient. While they have achieved some of their goals, like much needed corporate tax reform and across the board tax cuts, the overall law creates more complexity and uncertainty and creates winners and losers based on their state of residence or the industry in which you work.
Because the law is so complex, there is much ground not covered in this commentary. Below are some links to articles which go into more details on the provisions of the law.
Tax bill calculator that helps you to estimate how these changes are likely to affect you via New York Times
Comparison of current versus new policies via New York Times
Thorough analysis of the Tax Cuts and Jobs Act via Tax Policy Center
Business pass-through deductions and how they apply via New York Times
Sunset provisions of Tax Cuts and Jobs Act via Wall Street Journal (paywall)