For a little while longer, tax advisors are living parallel universes. Tax returns for 2017 must be calculated and filed under old law that existed until January 1. At the very same time, attention is being directed toward the post-tax reform laws and resulting long-term tax planning possibilities, as well as the short-term realities of determining 2018 tax payments. The 2017 side of things will take care of itself in the ordinary course, while planning under the new laws will generate a great deal of thought and action that is yet to come.
There has been no shortage of great, or at least interesting, ideas floated in the abstract by tax consultants of various stripes, suggesting ways to minimize taxes under the new tax reform package. While this thought leadership and early work of the commentators is helpful, it is not the most difficult part of adapting to the changes. That honor likely falls to the experts in the Treasury Department and the IRS, tasked with the jobs of issuing detailed guidance on how taxpayers are to comply with new and unclear statutory language. Yes, take a moment to thank in advance the Treasury-types in Washington who have a lot of complicated work to do, and it is to the benefit of all they do it right.
The other challenging part of life after tax reform will be undertaking, client by client, the analysis, assessment, consultation, recommendations, and implementation of new plans. This is where we come in. There are not very many ideas being discussed in the expert commentary that will be across-the-board solutions for every family or every business. Particular facts and circumstances might lead to a solution for one client that is very different from the right approach for another.
While all the areas of change in the tax reform legislation are too numerous to discuss in a newsletter, below is a brief mention of the few areas we most readily see as opportunities for value-added planning for clients.
A network of taxes inhibit the ability to maximize the transfer of wealth, that being the estate, gift and generation skipping tax system. The lifetime exemptions from those taxes were $5 million per person, and with an inflation adjustment had grown to $5.49 million in 2017. The tax reform change doubled the $5 million base per person to $10 million. With a retroactive inflation adjustment, the lifetime exemption from wealth transfer taxes is now $11,180,000. For married persons engaged in coordinated estate planning, the exemption thus becomes $22,360,000. This is an astonishing change in most respects (unless you had bought into the possibility of a full estate and gift tax repeal under the House Ways and Means Committee proposal that did not pass).
The wrinkle is that due to Senate budget scoring restrictions, Congress had to write the law to expire after 2025, so it is quite possible this will be a temporarily bloated exemption that is available for tax-free wealth transfer. Most families in control of significant wealth, whether exceeding or still somewhat within those exemption amounts, need a deep dive analysis in how best to make use of the new wealth transfer capacity. This is especially the case given that the current rules for step-up in cost basis of appreciated assets upon death were untouched in the new tax bill. This is a welcome combination of tax rules, at the cost of some complexity that will go with making best use of the planning options.
The next question arises as to how this increased level of tax exemption would play out in a shifting political world, and the multiple choice test is:
Some of these actions of course would require the complicity of a willing President. Our bet is to avoid assuming the present exemption of $10 million, as inflated, will last more than the next major political shift in 2020? 2024? Some other time?
A much-discussed shift as a result of tax reform has been the flip of corporate tax rates, now lower than the individual tax rates. The picture was muddled by Congress' attempt to battle shouts of inequity by the small business community by further engineering tax rates, since much of the business activity in the U.S. is conducted in the form of pass-through entities. Therefore a hybrid effective tax rate was installed to give business owners of LLCs, S corporations, sole proprietorships, etc. an effective tax rate that is lower than individual tax rates, but not as low as the 21% tax rate now applied to income taxes paid by corporations. The mechanism for achieving this goal is a deduction equal to 20% of domestic net business income, with many, many caveats, exceptions, and special rules too numerous to dissect here.
An important aspect of the deduction against business income is that it appears active business management is not required in order to be entitled to the 20% deduction. A small minority share owner who is really a passive investor is just as able to claim the deduction against the investor's share of the business income as is the full time active business owner. This observation leads to potential planning possibilities for investors, not just for those who would ordinarily be thought of as business owners.
High net worth investors often pursue an asset allocation strategy of direct investing in operating companies, or investing in private equity funds that hold a portfolio of private operating flow-through companies. The net business income allocated to the investor will be eligible for the 20% deduction taken at the individual tax return level. For clients with significant investment holdings in partnerships, LLCs and S corporations that produce business income, this area of the new law will keep planners and clients busy.
Any time our politics and policy lead to similar income levels being taxed differently based on the character of the income, tax advisors see opportunity. We now have a tax code that even more than before taxes different classes of income in a divergent manner, from interest income and short-term capital gains, to business income vs. corporate earnings, to long-term capital gains and qualified dividends. Tax drag will become even more important in evaluating investment strategies, and what vehicle is used for the investment, such as after-tax accounts, grantor trusts, IRAs, Roth IRAs, charitable trusts and foundations, non-grantor trusts, C corporations, and so on.
Bear in mind the net investment income tax of 3.8% on investment earnings, and the 0.9% Medicare surcharge tax on earned income, both created under the Affordable Care Act, remain in place. The interaction between the buckets of income listed above, and the self-employment tax and net investment income tax, was not drafted in a cohesive manner, so odd results can occur to the good or to the bad. We also must account for the patchwork of state income tax rules that are not uniform with each other.
A normally stable area of tax law in periods of political and policy change, the ability to take itemized deductions on the personal tax return, was altered to a large degree. It is well-known that state and local taxes are now only deductible up to $10,000 per year, that medical deductions will go away after 2018, that mortgage interest deductions were limited (though not substantially), and that miscellaneous itemized deductions were eliminated. It is this last item that might lead to the most amount of analysis and planning.
For many clients, the annual amount of professional fees and other costs incurred in the production of investment income, and obtaining all sorts of professional services and advice, can be substantial. So the loss of expense deductibility can lead to an effective tax increase, though Congress would rather it be thought of as simplification.
However, we think there will be some pockets of opportunity for supporting the continued deductibility of these expenses where the family's investment and business activities match up with certain tax law principles. Of course, what might accompany the tax-reducing planning is an uptick in complexity, so again it must be noted the right thing to do will be a case-by-case decision.
This will be an interesting year, as we advance through the conversion to a re-designed tax code. It will be rewarding to work with our client families to implement some new ideas that help keep taxes minimized.