Taxation of Individuals
The Tax Cuts and Jobs Act (the Act) provides seven tax brackets (10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent) for individuals paying taxes on their ordinary income, such as wages. The Act repeals the Affordable Care Act’s individual mandate penalty. The Act did not repeal, however, the 3.8 percent net investment income tax, nor did it remove the additional payroll and Medicare taxes, resulting in a possible top marginal rate of 40.8 percent for individuals. These new individual tax rates will sunset on December 31, 2025.
Generally, fewer individuals will itemize their deductions for tax year 2018 because although the Act eliminated personal exemptions, it doubled the current standard deduction. In addition, although charitable deductions were left untouched, the mortgage interest deduction will be based on a new $750,000 limit instead of the prior $1,000,000 limit for home acquisition debt. State and local taxes for individuals can also still be itemized and deducted, but only up to $10,000. There was previously no limit on the amount of state and local taxes that could be deducted on personal income tax returns.
Taxation of Pass-through Income
The Act provides a 20-percent deduction for pass-through entities, such as partnerships, S corporations, and sole proprietorships. Business income from specified services (including health, law, accounting, consulting, athletics, financial services, brokerage services, and certain other services) is ineligible for the deduction, except for taxpayers with income below certain thresholds. Taxpayers with taxable income not exceeding $157,500 (or $315,000 in the case of a joint return) are exempt from the prohibition on specified services. As with other individual income tax provisions in the Act, the 20-percent deduction for pass-through entities will sunset on December 31, 2025.
Corporate tax rates are reduced from a maximum rate of 35 percent to a flat rate of 21 percent under the Act. The corporate alternative minimum tax is also eliminated, unlike the individual alternative minimum tax which was retained. Although the Act has eliminated most corporate deductions and credits, it provides for the immediate write-off of the cost of business investments under bonus depreciation.
Estate and Gift Taxes
The Act increases the federal estate and gift tax unified credit basic exclusion amount to $10 million (adjusted for inflation from the same 2010 base year), effective for decedents dying and gifts made after 2017 and before 2026. The Act increases the federal GST exemption amount to $10 million (adjusted for inflation from the same 2010 base year), effective for generation-skipping transfers made after 2017 and before 2026.
Employee Tax Benefits
Generally, a deduction for compensation paid or accrued with respect to a “covered employee” of a publicly traded corporation is capped at $1 million per year. Covered employees include the CEO, CFO, and the three highest-paid employees. Pre-reform, the deduction limitation did not apply to commissions or performance-based remuneration (including stock options). The Act repeals the commission and performance-based compensation exceptions.
Section 83(i) of the Internal Revenue Code will provide new tax benefits to employees of certain startup companies. Here, a qualified employee may make an election to defer income with respect to qualified stock so that no amount is included in income for up to five years or until a specified event occurs, such as the company going public. The company must have a written plan that provides RSUs or stock options to at least 80 percent of the employees of the company. Employers must provide notice that the employee may be eligible to elect to defer income. Certain highly compensated employees are explicitly excluded.
Subtitle D of the Act contains the international tax provisions. Here, the Act creates a new territorial system of taxation by exempting certain foreign income of U.S. corporations from U.S. taxation.
Although President Trump signed the Act into law, Americans can expect further legislation to clarify and modify the new rules. Outside of budget reconciliation, any subsequent bills are going to require 60 votes to pass in the Senate, which means some Democrats will also have to be on board. In the interim, we will have to rely on further IRS guidance to fill in the gaps of this tax reform legislation.