2018-09-11 Podcast 5 TAXES_mixdown
[AUDIO INTRODUCTION] Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, President of BMT Wealth Management.
[SPEAKER: JEN FOX] Today, I’m speaking with Jennifer Marshall, the Tax Manager at BMT Wealth Management. Jennifer, welcome.
[SPEAKER: JEN MARSHALL] Thanks, Jen.
[SPEAKER: JEN FOX] Today, we’re discussing the 2017 Tax Cuts and Jobs Act and some of the provisions that are most likely to impact and provide opportunities for individuals and businesses. Before we get into the details, I’d like to mention that many of the corporate or business deduction changes of the Tax Act were made permanent, while most of the individual provisions are set to expire in eight years or in 2025. Of course, in taxes, nothing is ever really permanent, since taxes are always subject to change as new legislation is introduced.
So let’s start with the change in the corporate tax rate. Jennifer, what kind of changes have been incorporated in relation to business income?
[SPEAKER: JEN MARSHALL] Well, Jen, the corporate tax rate was changed to a flat 21%. And this is really in stark contrast to the previous tiered tax rate system with a top tax rate of 35%. As a matter of fact, it even had a tier in there that was as high as 38%. So this reduction is really a huge benefit to C corporations and will allow these US corporations to better compete with their foreign competitors, who have long benefited from a much lower corporate tax rate.
[SPEAKER: JEN FOX] Yeah. I’ve read that an increase in dividends, spending, and payroll have already been attributed to this. But what about businesses that aren’t organized as a C corporation?
[SPEAKER: JEN MARSHALL] Well, in order to create a level playing field for smaller companies, many of which are privately held and structured as pass-through entities, there’s a new 20% deduction on qualified business income. So these are sole proprietorships, S corporations, certain limited liability companies and partnerships. These are all the common pass-through entities. And pass-through meaning that the income, deductions, and credits of the business pass directly to the owner’s individual income tax return. So the tax break being offered to these entities is in the form of a 20% deduction on qualified business income.
[SPEAKER: JEN FOX] So, of course, the tax law is never straightforward. So what are some of the qualifications and limitations of this deduction?
[SPEAKER: JEN MARSHALL] Yes. Changes in the tax law are never straightforward. So to start with, the entity itself must be a qualified trade or business. And this excludes what the IRS has termed specified service trades or businesses or SSTBs. It’s those businesses engaged in fields of health care, law, accounting, actuarial science, performing arts, financial services, consulting, investment management services. Essentially, we’re talking about any trade or business where the principal asset of such a trade or business is the reputation or skill of one of the employees or its owners. And this is just to name a few.
However, even an SSTB can qualify for the deduction, provided that the individual’s taxable income does not exceed $157,500 for those filing as single or $315,000 for married filing joint. But taxable income that’s in excess of those amounts will then start to reduce the 20% deduction. And then the deduction is altogether eliminated for individuals where their taxable income is in excess of $315,000 for single filers or $415,000 for individuals that are married filing joint.
In addition, the income also has to be domestic income, meaning that foreign-earned income or foreign-sourced income will not qualify for this deduction. In addition, income such as REIT dividends– which are real estate investment trusts– any qualified cooperative dividends, and also qualified publicly traded partnership income is also specifically excluded.
[SPEAKER: JEN FOX] So, clearly, not the straightforward exclusion that we would have hoped for. But what about nonservice-related businesses? Is their deduction a straight 20%?
[SPEAKER: JEN MARSHALL] Well, wouldn’t that be lovely, a straight 20% deduction with no complications. Nice try, but no. While the deduction– it very well could be a straight 20%. It could also be limited to the lesser of 50% of the business’s W-2 wages or the sum of 25% of W-2 wages plus 2 and 1/2% of the unadjusted basis of all qualified property.
And the IRS has already prescribed several methods for how you would calculate the W-2 wages of the business. But, essentially, it boils down to the total earned income of all employees that are subject to federal tax and reported to the Social Security Administration.
[SPEAKER: JEN FOX] So it certainly sounds like a lot of factors and calculations are going to be needed to make the determination of the actual deduction. Will all the information be available from the current year records?
[SPEAKER: JEN MARSHALL] Sure. Many of these figures that will be necessary are current year figures. It’s going to be income and deductions.
But the amount of the unadjusted basis for qualified property, that will need to be found in the year when the property was originally placed in service. So the unadjusted basis immediately after acquisition– or UBIA– for qualified property is the original cost or dollar amount of tangible property that’s used in a trade or business, subject to the allowance for depreciation, in the year that it’s first placed into service. This means that property that has been fully depreciated will be included in this calculation. So it’ll be necessary to determine the UBIA for all property that is currently in service, even if it’s no longer on the books.
[SPEAKER: JEN FOX] So in thinking about this new deduction, are there strategies related to the new deduction? Does it provide any tax planning opportunities?
[SPEAKER: JEN MARSHALL] I think it certainly does. There are potential tax planning strategies involving the ownership of a pass-through entity and the potential to break out income.
[SPEAKER: JEN FOX] Interesting. How would you be able to break out such income?
[SPEAKER: JEN MARSHALL] For example, you could change a gifting strategy to transferring an interest in a pass-through entity instead of cash to an irrevocable trust. So the trust itself is actually a separate taxpayer, and, therefore, the trust would be able to take its own 20% business deduction from the income that would flow through to the trust due to the transfer in ownership or the gift of the pass-through entity.
So if you make gifts into multiple trusts set up for different individuals– say children and grandchildren– you can then multiply that deduction by the number of separate trusts set up.
[SPEAKER: JEN FOX] Incredible. So what other provisions of the new Tax Act will impact an individual’s taxable income?
[SPEAKER: JEN MARSHALL] Well, I’m sure many people have heard of the increase to the standard deduction. And this is specifically what will simplify many returns. As a matter of fact, in response to the potential simplification, a new postcard return has been released by the IRS. And what it boils down to is the thinking that with such a higher standard deduction, there will be many people that will no longer need to itemize.
The standard deduction itself has been increased to $12,000 for single filers, $18,000 for head of household, and $24,000 for married filing joint. The standard deduction essentially represents the maximum amount of income that can be generated or earned free of tax. So an individual will not pay taxes on the first $12,000 of income for single. And a couple filing jointly would not pay tax on the first $24,000 of income.
However, the act has eliminated and reduced other deductions, including the elimination of personal and dependency exemptions and the reduction or elimination of several itemized deductions as well. This includes a new $10,000 limitation on the deduction for state and local income taxes, real estate taxes, and personal property taxes combined. Formerly, taxpayers were permitted an unlimited deduction for both real estate taxes and state income taxes. So I’m sure people have seen a lot in the media, because taxpayers that are residing in states with a high income tax rate and/or a high property tax rate will most likely be impacted and may see an increase in their federal tax liability.
In addition, all miscellaneous itemized deductions have also been eliminated, including investment subscription costs; it would include the tax preparation fees, and also investment management fees.
[SPEAKER: JEN FOX] OK. So with so many deductions being limited or eliminated, what planning strategies can clients incorporate to help reduce the tax liability?
[SPEAKER: JEN MARSHALL] Well, there are many tax planning strategies that are still available, such as taking advantage of the qualified charitable distribution from an IRA. And this deduction was available in previous years, but now it has been made permanent by this new Tax Act. And this deduction– which permits taxpayers who have attained the age of 70 and 1/2, which is the age when you must start taking the required minimum distribution or RMD– allows the ability to direct up to a $100,000 distribution from their IRA directly to a favorite charity.
So the advantages of this strategy include that you’re able to satisfy your RMD for the tax year. It eliminates the need to include that distribution in your income. And it mitigates the potential loss of the charitable deduction for taxpayers that will be utilizing this new higher standard deduction.
So, in short, what it does is, it converts a traditional below-the-line deduction that would have been in the form of a charitable deduction into an above-the-line deduction by circumventing the need to include the IRA distribution in income. And that’s a very key point.
It’s important to point out that there are several benefits to lowering the adjusted gross income. It includes things such as being able to reduce the amount that is paid for Medicare premiums. It would allow taxpayers to qualify for additional tax credits. It could potentially allow for a higher deduction for medical expenses. And, also, it could be a reduction in the amount of Social Security benefits that are taxable as well. And these are just to name a few.
[SPEAKER: JEN FOX] Jennifer, thank you. There’s so much material to cover with this new Tax Act. But, for now, we’re going to wish everyone well. And thank you so much for joining us. We look forward to presenting more tax podcasts in the future.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2018. All rights reserved. Visit us online at bmtc.com/wealth.
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