Tax planning following the Tax Cuts and Jobs Act

The legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made sweeping changes to the tax law, reducing the C corporation top income tax rate from 35% to 21%, creating a 20% tax deduction for qualified business income under new Sec. 199A, limiting the state and local tax (SALT) deduction to $10,000, increasing the standard deduction to $12,000 for single taxpayers and $24,000 for married taxpayers filing jointly, doubling the estate tax applicable exclusion amount, eliminating the ability to recharacterize Roth IRA conversions, expanding the scope of Sec. 529 education plans, further limiting interest deductions, and doubling the Sec. 179 expensing amount. This column discusses some of the planning implications of these changes.

While the TCJA improved the tax consequences for both C corporations and the owners of passthrough entities, the improvements for C corporations were more substantial. Thus, C corporations are somewhat more favorable relative to passthrough entities following passage of the TCJA. The tax rate on operating income dropped by 40% for C corporations (35% to 21%), but only by 25.25% (39.6% to 29.6%) for passthrough entities that fully qualify for the 20% Sec. 199A deduction (top individual rate of 37% × 80% of income). This means that the initial tax on C corporation income may now be significantly lower for C corporations than for S corporations (21% vs. 29.6%). In addition, the TCJA limits the SALT deduction to $10,000 for individuals but imposes no limit on the deduction for C corporations. Finally, the new C corporation rate is permanent, while the 20% Sec. 199A deduction sunsets at the end of 2025.

The overall tax paid on passthrough entities will generally continue to be lower, however, because of the second level of tax on C corporation owners when the income is distributed or the stock is sold. Dividends are generally taxed at 23.8% for affluent shareholders who are subject to the net investment income tax, and the same 23.8% rate applies to sales of C corporation stock. This almost doubles the effective tax rate on C corporation income: [0.21 + (0.79 × 0.238)] = 0.21 + 0.18802 = 39.802%.

However, two factors may increase the effective rate of tax for S corporations or decrease the effective tax rate for C corporations. There are important limitations on the Sec. 199A deduction, so it might not help some passthrough businesses very much. Some will lack the W-2 wages or basis in property necessary to gain a significant benefit from the new deduction. This might substantially increase the rate of tax paid on passthrough income, perhaps to as high as the top individual rate of 37%.

In addition, C corporations may be able to mitigate the effects of the second level of tax. First, the second level of tax is not payable until the income is distributed as a dividend or until the stock is sold. If shareholders do not need the dividends, there could be substantial tax deferral. Second, the second level of tax might never be paid at all. If dividends are not paid and the shareholder dies while owning the stock, the heirs will receive a step-up in basis, eliminating the increase in the stock's value due to the retained earnings. Third, C corporations can pay shareholder-employees deductible wages, fringe benefits, and deferred compensation instead of dividends. Thus, comparing the effective tax rates for C corporations and passthrough entities will require a detailed analysis of the facts of each case.

Taxpayers who live in high-tax states like New York and California have long created trusts in other states that do not tax trust income to eliminate their state income tax exposure. The most popular states for these trusts are Nevada, where the trusts are referred to as NINGs (Nevada incomplete gift nongrantor trusts), and Delaware, where they are referred to as DINGs (Delaware incomplete gift nongrantor trusts). These trusts have always been capable of creating dramatic tax savings over time or perhaps on a sale of a highly appreciated asset, but the savings will be substantially greater following enactment of the $10,000 limit on the SALT deduction, as illustrated in the following examples.

Example 1: In 2017, Taxpayer T has $250,000 of annual income from an investment portfolio. T is in an effective 40.8% federal tax bracket (39.6% + 1.2% phaseout of itemized deductions for high-income taxpayers). T lives in a state with a 10% state income tax rate and can deduct 100% of the state tax paid. If T does no planning, he will pay $25,000 in state income tax each year (0.1 × $250,000). Before the TJCA, T was able to deduct the full $25,000 on his federal income tax return, reducing his federal income tax by $10,200 (0.408 × $25,000). As a result, the state income tax had a net cost of $14,800 to T ($25,000 — $10,200). T could save this $14,800 each year by transferring the portfolio to a trust in a state that does not tax trust income. If T could reinvest the annual tax savings with an 8% annual return, the savings would grow to $677,277 after 20 years.

The TCJA limits the SALT deduction to $10,000. This means that the tax savings from an ING trust will now be even greater.

Example 2: Assume that T's tax rate did not change under the TCJA and the facts are the same as in Example 1, except that T is filing a return for 2018 and can now deduct only $10,000 of state income tax. T will again pay $25,000 in state tax, but his SALT deduction will be limited to $10,000. This will reduce T's federal income tax by only $4,080 (0.408 × $10,000), making the net cost of the state tax $20,920 per year. If an 8% return is again assumed, the savings would now grow to $957,340 after 20 years. Thus, the new $10,000 limitation on the SALT deduction makes a powerful tax planning strategy even better.

It may also be possible to use ING trusts to avoid state capital gains tax on sales of assets with large built-in gains, but careful planning would be necessary to avoid step-transaction or substance-over-form arguments from the IRS.

To achieve the desired results, INGs must be carefully structured. An ING must have the following characteristics:

• The trust must be located in a state that does not tax trust income: Seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) do not have an income tax so they do not tax trust income at all.
• The trust cannot be subject to tax in the settlor's home state: Many states treat trusts as resident trusts if the grantor was a state resident when the trust was created regardless of where the trust is located. These include Connecticut, the District of Columbia, Illinois, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, Ohio, Oklahoma, Pennsylvania, Utah, Vermont, Virginia, West Virginia, and Wisconsin. ING trusts will not help taxpayers in these states because the trust income will be taxed by their home state.
• The trust cannot be a grantor trust: If the trust is a grantor trust, the settlor will be treated as the owner of the trust (Sec. 671). As a result, all income will be added to the settlor's Form 1040, U.S. Individual Income Tax Return, and will be subject to tax in the settlor's home state.
• The trustee must have the power to make discretionary distributions to the settlor: Taxpayers are typically not willing to make an outright transfer of their investment assets. They either want income distributions or the possibility of reacquiring principal if they need it, treating the ING as a rainy-day trust. Thus, the trustee must be given the power to make discretionary distributions to the settlor.
• Transfers to the trust must be incomplete gifts: Finally, the settlor must retain enough control over the transferred assets to avoid making a completed gift that is subject to the gift tax.

Although a detailed discussion of the mechanics of an ING trust is beyond the scope of this column, IRS Letter Rulings 201652002, 201718004, and 201742006 could be used as a model.

The TCJA increased the limit for contributions to public charities and private operating foundations from 50% of adjusted gross income to 60%. This will not only enable taxpayers to increase charitable deductions for the current year, but will also free up more carryforward deductions from earlier years.

The TCJA also includes provisions that will reduce the tax benefits of charitable giving. Taxpayers can benefit from the charitable deduction only if their total itemized deductions exceed their standard deduction amount. The law's new standard deduction amounts ($24,000 for married filing jointly, $12,000 for single filers) are a high threshold for most taxpayers and are more difficult to reach with the $10,000 limitation on SALT deductions. Therefore, the increase in the standard deduction amounts will reduce or eliminate the tax benefit of charitable giving for many moderate-income taxpayers. In addition, the TCJA doubles the estate tax applicable exclusion amount to $11.18 million (for 2018). This will tend to reduce the estate and gift tax benefit of charitable giving for wealthy taxpayers. Finally, reducing income tax rates reduces the value of the charitable contribution deduction and any other deductions.

Planning

Taxpayers should consider bunching charitable deductions into some years and itemizing their deductions in those years and claiming the standard deduction in other years.

Example 3:  Married taxpayers contribute $12,000 each year to their church and have $8,000 of other itemized deductions. If they claim the $24,000 standard deduction in each of the next three years, they will get total deductions of $72,000. However, if they claim the $24,000 standard deduction for years 1 and 2 then bunch three years' worth of charitable donations into year 3, the couple can claim a total of $92,000 of deductions over the three-year period ($24,000 in year 1, $24,000 in year 2, and $44,000 in year 3).

Historically, estate planners were more concerned about reducing estate tax than about reducing income tax for heirs. Since 2001, however, the number of taxable estates has declined dramatically as the applicable exclusion amount was gradually increased. This trend continued with the TCJA doubling the exclusion amount to $10 million (indexed for inflation) for 2018 through 2025. With this high exclusion amount, less than one estate in a thousand is expected to be taxable. Thus, for most estates, avoiding estate, gift, and generation-skipping transfer tax is no longer an issue. Instead, estate planning will focus on ways to increase basis, particularly the stepped-up basis at death provided by Sec. 1014.

Basis-building strategies for nontaxable estates

Taxpayers who do not expect to have a taxable estate should consider the following strategies for building basis.

Minimizing lifetime gifts: If assets are transferred during life, heirs take a carryover basis from the donor. By contrast, if the assets are held until death, the heirs take the assets with a stepped-up basis. Thus, assuming that assets are increasing in value, dying with the assets is more favorable from an income tax perspective than transferring the assets during life. If a taxpayer wants heirs to have assets earlier, the taxpayer should consider making gifts of high-basis or slower-appreciating assets.

Retaining powers over transferred assets: A basis step-up is available not only for property owned at death but also for property transferred during life that is included in the gross estate under one of the estate tax string provisions (Secs. 2035-2038) (Sec. 1014(b)(9)). For example, transferred property is included in the gross estate under Sec. 2036 if the taxpayer transfers property but retains a right to income from the property. Transferring property and retaining one of these strings would enable the taxpayer to provide an immediate benefit to heirs without losing the basis step-up at death.

Making transfers to older relatives: Another way to minimize the income tax disadvantage of making lifetime transfers would be to transfer property to elderly relatives with relatively short life expectancies. The older relative would die with the property and bequeath it back to the donor with a stepped-up basis. Then the donor could gift the property to children with a basis equal to its fair market value. It is important to note, however, that if the older relative died within one year after receiving the property, a basis step-up would be denied under Sec. 1014(e).

Substitution power: One of the most popular powers used to create grantor trust status is the Sec. 675(4)(C) substitution power. This power enables the grantor to transfer high-basis assets or cash to a trust in exchange for low-basis assets. The settlor could then hold these low-basis assets until death and create a basis step-up for heirs.

Selection of assets to die with: Some assets are particularly favorable to own at death. For example, the maximum capital gains rate on a sale of collectibles is 28%, not the usual 20%, making a basis increase on these assets particularly favorable. Loss assets are especially unfavorable because the basis adjustment at death would wipe out the loss. Those assets should generally be sold during life to recognize a capital loss. Finally, income in respect of a decedent (IRD) assets, such as IRAs and qualified plans, are not good assets for basis building because they do not receive a basis step-up at death (Secs. 1014(c) and 691(a)(2)).

Under prior tax law, Sec. 529 plans were designed to offer a tax-advantaged savings tool for higher education costs. In addition to the earnings in the account being tax-free if used for higher education, over 30 states allow a form of deduction or credit from state income taxes for contributing to these accounts. The TCJA provisions for 529 plans have expanded the usefulness and planning opportunities available for families by allowing up to $10,000 in these plans to be used for elementary and high school costs annually at public, private, or religious institutions.

Planning

Contributions to 529 plans can be made by anyone, not only family members, and qualify for the $15,000 annual gift tax exclusion. Taxpayers can elect to contribute up to $75,000 in one year and treat the contribution as made ratably over a five-year period. This allows the full $75,000 to begin accumulating tax-free in year 1 until it is needed for education costs from kindergarten through college. If the growth exceeds needed costs for education, the account owner can transfer funds to another beneficiary to use for qualified expenses.

Additionally, the TCJA allows families to roll money from a 529 plan into an ABLE account (created by the Achieving a Better Life Experience Act of 2014, P.L. 113-295) for expenses associated with special-needs children. The ABLE account must be owned by the designated beneficiary of the 529 account or a member of that designated beneficiary's family. These rollovers are income tax and penalty free for rollovers from 2018 through 2025.

The TCJA made a drastic change to the planning opportunities provided by Roth conversions by eliminating taxpayers' ability to recharacterize their conversions. Under prior law, a taxpayer could convert a traditional IRA to a Roth IRA and had until Oct. 15 of the following year to see if the conversion had been successful. If not, the taxpayer could recharacterize the Roth conversion contribution as a contribution to a traditional IRA and avoid paying tax on the conversion. This rule allowed the taxpayer to recharacterize the Roth conversion and "retry" the strategy the following year. Roth conversions may still be advantageous, but an even more detailed analysis is required by tax professionals without the safety net of the recharacterization.

A number of tax provisions were affected by the TCJA that require CPAs to take an in-depth approach to planning for clients. These changes include the following:

Sec. 199A deduction

Sec. 199A generally provides a 20% deduction for the qualified business income (QBI) of passthrough entities (partnerships, S corporations, limited liability companies, and sole proprietorships). When a taxpayer's taxable income exceeds $157,500 for single taxpayers or $315,000 for married taxpayers filing jointly, however, the deduction is limited to (1) 50% of the W-2 wages paid by the entity or (2) 25% of W-2 wages plus 2.5% of the unadjusted basis of the entity's depreciable property. Thus, the key to Sec. 199A planning for real estate owners with taxable income above the threshold amounts is increasing the W-2 wage and unadjusted basis limitation amounts. The W-2 prong of the limitation can be increased by replacing independent contractors with employees because amounts paid to independent contractors do not count as W-2 wages. The unadjusted basis prong can be increased by purchasing equipment that is qualified property for purposes of Sec. 199A that they currently lease.

Interest expense deduction

The TCJA included a provision that limits the deduction of business interest expense (less business interest income and floor plan financing interest) to 30% of a business's "adjusted taxable income," tested on an entity-by-entity basis. Disallowed interest is carried forward indefinitely. Adjusted taxable income is computed without regard to any item of income, gain, deduction, or loss that is not properly allocable to a trade or business, business interest or business interest income, net-operating-loss (NOL) deductions, Sec. 199A deductions, and any depreciation, amortization, or depletion before 2022. A real property trade or business (as defined in Sec. 469(c)(7)(C)) can make an irrevocable election to be excluded from the interest limitation if it uses the alternative depreciation system (ADS) method of depreciation for any nonresidential real property, residential rental property, and qualified improvement property. A farming business can make the same election if it uses the ADS method of depreciation for modified accelerated cost recovery system property with a recovery period of 10 years or more.

Sec. 179 expensing

The new tax law increases the expensing limitation of Sec. 179 from $500,000 of property to $1,000,000. The provision also increases the phaseout limitation to begin when property placed in service during the tax year exceeds $2,500,000. The TCJA also expands the definition of qualified real property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with the furnishing of lodging and certain improvements to nonresidential real property including roofs, HVAC systems, fire protection, and security systems.

Net operating losses

The TCJA amended Sec. 461 to include a subsection (l), which disallows the NOL of noncorporate taxpayers if the amount is over $250,000 ($500,000 in the case of a joint return). The threshold amount for disallowance will be adjusted for inflation in future years. The disallowed amount is carried forward as an NOL to the following tax year; there is no carryback provision.