Whether we like it or not, the “Tax Cuts and Jobs Act” (“TCJA”) has been signed into law. The purpose of this article is not to discuss the merits of TCJA, but rather address what New Yorkers can do to minimize the tax bite that resulted from its passing. Just as one of the laws of Physics is “For every action, there is an equal and opposite reaction,” the laws of tax are no different. Some states such as New York are talking about instituting a deductible payroll tax to replace the non-deductible personal income tax as a reaction to TCJA. However, we can’t rely on our state politicians as our sole reaction. Here are some suggestions as to what each business and individual should discuss with their tax advisor in response to the TCJA.
- Pass-Through Entity 20% Deduction: This is where significant planning time will be spent. For 2018, individual owners of pass-through entities with “domestic qualified business income” (“DQBI”) are permitted a deduction of up to 20% of such income subject to certain limitations based on wages and “business capital.” In other words, an individual that owns a pass-through entity with DQBI of $100 could pay tax on $80 after this 20% deduction. This effectively reduces the maximum Federal personal income tax rate from 37% to 29.6%.
Based on a strict reading of the law, different forms of business (Sole Proprietorship, S Corporation or Partnership) could result in differing amounts of this deduction for the same business due to the limitations referred to above. The reason we say a “strict reading of the law” is that generally when there is confusion about a section of a new tax law, we can look to what the drafters were trying to accomplish and who was supposed to benefit to determine how to interpret such legislation. Unfortunately, such clarity does not exist for this section of the TCJA. We can only hope that future technical corrections will provide additional clarification.
Again, under a “strict reading of the law,” wage income is not included in the definition of DQBI. Accordingly, business owners of S Corporations may want to minimize their salaries to minimize their exposure to higher tax rates. A single owner of an S Corporation will be tempted to “optimize” their salary to maximize this deduction and minimize their wages. Such calculations are subject to reasonable compensation rules. Employees that are borderline independent contractors may push harder to be considered independent contractors or partners, in the case of partnerships, as their highest tax rates could be reduced from 37% to 29.6%.
Finally, individuals with multiple pass-through business interests will be tempted to allocate income from business interests where this deduction is limited or not permitted to business interests where they are more easily able to benefit from this deduction. The simplest example is the doctor that owns their medical practice and the building in which they practice in two separate pass-through entities. Income from many professional service practices, including medical, generally are not included in the definition of DQBI; however, income from real estate is included in DQBI. Simply by raising the rent the medical practice pays the real estate entity, the doctor can turn non-DQBI income into DQBI income and be entitled to this additional 20% deduction. Again, IRS reasonableness standards come into play.
This analysis is just the tip of the iceberg; this is where significant time should be spent planning.
- C Corporation 21% Tax Rate: The C Corporation tax rate was reduced from a maximum of 35% to a flat 21% in connection with TCJA. While this is an enticing rate, there are still state taxes to consider as well as the second level of tax when the income is distributed to the corporate owners. Generally, the C Corporation route will not make sense due to the second level of tax, especially in high tax states. Also, longer term considerations must be addressed. One such consideration is if the owner believes that the ultimate sale of the business were to be an asset sale. The S Corporation typically makes more sense in the asset sale scenario. (These are general rules as there are certain scenarios where a C Corporation will make more sense.)
- Itemized Deductions: Very few itemized deductions survived the TCJA. One of the survivors is the charitable deduction. Couple this with the higher standard deduction and it could make sense for certain taxpayers to “bunch” their deductions into one year. To get the benefit of itemized deductions in at least one year, donate $20K in year 1 and zero in year 2, rather than $10K each in years 1 and 2. This way, it is more likely that you will be able to utilize itemized deductions in year 1 and still get the standard deduction in year 2. If you donate $10K in each year, you may end up with the standard deduction in both years.
- Depreciation: 100% asset expensing and expanded section 179 asset expensing were included in the TCJA. The takeaway here is to maximize the depreciation benefit and consider state consequences.
- Kiddie Tax: Pre-TCJA, children that qualified for the “Kiddie Tax” could shelter up to $2,100 of investment income from their parents’ tax rate at a very low tax rate. Under the TCJA, assuming the parents are in the highest tax bracket, qualifying children can now shield up to $12,500 of unearned income at tax rates lower than the maximum tax rate.
- 529 Plans: Under the TCJA, taxpayers may use 529 plans to pay for private schools from elementary onward. Previously, such plans could be used to pay for qualified college expenses only. There are two potential benefits with the 529 plan. The first is that some 529 plans permit a state tax deduction upon contribution and the second is that the income earned is tax-free if used for qualified expenses.
As with the Pass-Through Entity 20% Deduction, these additional items relate to the entire TCJA and also merit careful planning.
In addition to the domestic tax changes referred to above, the TCJA contains a myriad of international tax changes that has altered the playing field for US companies with foreign operations and US shareholders in foreign corporations. Other international corporate structures and individuals can also be affected. As with some of the domestic provisions above, there is a cloud of confusion surrounding several of the international provisions contained in the TCJA. However, there are steps that you can take to minimize your exposure to these issues. Such considerations are beyond the scope of this article; however, you should consult your tax advisor to address these issues.
Finally, above and beyond the TCJA, there are already a myriad of often-missed tax benefits that could apply to a business. Two such benefits are: (1) the research credit, which is available for developing new technologies, software, and processes as well as streamlining processes as some examples of its application, and (2) IC-DISCs for manufacturers, producers and sellers of US products to foreign customers. Both benefits are still available post-TCJA.
The bottom line: over the course of the year, and for some sooner than later, every business and individual should review their situation with their tax advisor to make sure they are maximizing their tax benefits. Once the technical corrections to the TCJA are deployed as we hope/expect later in 2018, they should then re-confirm that they are maximizing their opportunities from the tax perspective.
 Please note that most TCJA provisions are effective January 1, 2018.
This article does not necessarily reflect the views of CMM and does not constitute legal or tax advice. Please consult with your accountant about your particular tax situation.