The New Tax Bill: Highlights, Myths Dispelled and the Flow Through Business Deduction
First and foremost, I want to take this opportunity to brag about the 8 hours I spent this past Friday in a seminar about the new tax bill and the countless hours I have spent reading both said bill and the recently released 640 page Bipartisan Budget Act of 2018. All this and we still expect thousands of pages of literature on the mechanics of how all of this will work. Take a moment and let go of that jealousy...deep breaths, maybe some downward dog if that's what it takes. I don't want your invidiousness (nice SAT word!) to prevent you from absorbing the info below, much of which could be quite relevant to your tax situation moving forward.
Before we dive in, some basics of interest contained in the new tax bill effective as of January 1, 2018:
- The standard deduction has nearly doubled. For single (and married separate) filers, the deduction has gone from $6500 to $12,000 and for married joint filers the standard deduction has gone from $13,000 to $24,000
- Personal exemptions have been eliminated. In 2017, you received a $4050 for each dependant claimed on your return. Therefore, if you filed a married joint return and had 2 dependant children in 2017, you were getting a $16,150 exemption. Wave goodbye. Gone. Sayonara.
- The deduction for state and local taxes, including real estate taxes, is now capped at $10,000 per year. Not ideal for many people living in high tax states, especially those in high real estate tax districts in and around major metropolitan areas
- Mortgage interest has a new cap. You can now only deduct mortgage interest on the first $750k of mortgage principle (this is effective December 15th, 2017 NOT Jan 1, 2018). However, if you're mortgage originated before the new tax bill came into effect, the old $1M cap is grandfathered in...your ability to deduct mortgage interest is generally unchanged (there are exceptions to this rule for equity lines as I'll describe later on). There are also some exceptions for those who entered into purchase agreement in the final few weeks of 2017 so if you purchased a home or entered into contract to do so in December of '17, you should contact your tax advisor to see what your deductibility limits are.
- The child care credit has been increased to $2000 per child and the income phase out to get the credit has increased significantly to $400,000 of adjusted gross income for married joint filers ($200,000 for single filers)
- 529 plans can now be used to fund up to $10,000 per year of a student's education at public, private or religious elementary or secondary school. It's not just for college anymore! (States with lifetime limits on 529 contributions have not yet issued changes to the funding limits to allow additional contributions enabling you to fully cover the cost of college education after pre-college usage).
Now that we've gotten some of the straightforward basics out of the way, let's start to dig in by explaining away a myth that many clients I speak with have read about...the elimination of the meals and entertainment deduction. The myth is this: starting in 2018 businesses can no longer deduct meals and entertainment. This is not all myth but certainly not all true. The truth relates to the 'entertainment' part of the rule. In general, the following are no longer deductible as business expenses as of January 1, 2018 even if they are directly related to your trade or business:
1) Any activity generally considered to be entertainment, amusement or recreation (think sporting event tickets, concert tickets, theater tickets, etc)
2) Membership dues with respect to any club organized for business, pleasure, recreation or other social purpose
3) A facility or portion thereof used in connection with any of the above items.
The myth relates to the meals part of the regulation. Businesses, including those that file using a Schedule C on the personal return, are still generally allowed to deduct 50% of food and beverage expenses associated with their business. This HAS NOT CHANGED from recent years. However, an interesting change of note is that taking an employee out to a meal is no longer deductible. There have been some other changes involving employer provided meals but I will not get into that here. You can always email or call for more detail!
Next, let's tackle home equity lines of credit (equity lines). The general myth being circulated is that home equity lines of credit are no longer deductible. Again, part true and part false, the devil being in the details. If you took out a home equity line of credit and it was used for the purpose of substantial improvements to your home, then it is STILL DEDUCTIBLE. If it was used for any other purpose, it is no longer deductible. The asterisk here is that the caps have changed even for loans that existed prior to the tax bill. If you meet the above condition, you can still deduct interest on $100k of equity line principle, however, if your loan existed prior to the new tax bill, you can now only take $1M combined between your primary and secondary loans (previously you could take the interest on a combined $1.1M of principle). If you have purchased a home since the tax bill was enacted, the total cap for your primary loan and equity line combined is the new limit, $750k.
For now, I will dive into one more topic, the new 20% deduction for flow through businesses. This is an area of much confusion, even for tax professionals. To clarify, for the purposes of this deduction, flow through businesses include sole proprietors, partnerships/LLCs/LLPs/etc, S-corps and trusts and estates. The 2 most common questions I field about this new deduction are are 'what the heck is this' and 'how do I qualify'. Both totally legit questions! What I am about to explain is both a bit confusing and a bit general but I will do my best to break it down to somewhat understandable terms. Each business really needs to be looked at individually, the ability to use this deduction resting on the company's individual merits.
A fairly simplistic answer to 'what the heck is this'...a noncorporate tax payer (read: you as an individual or married couple) who has qualified business income from a flow through entity is allowed a 20% deduction on their personal tax return. However, there are many restrictions, including profession type and income level. The easy part is this...if you have qualified business income (QBI) from one of the aforementioned business entity types and you have personal taxable income on your personal return of LESS THAN $315,000 if filing married joint ($157,500 if single), there are no limitations as to profession type placed on your ability to take this 20% deduction. You get the deduction. (Woohoo!!) Essentially, you get a deduction equivalent to 20% of your business income on your personal return. For example, if you had $150k of business income and you meet the personal taxable income limit mentioned above you get a deduction of $30k before your total tax is calculated. Seriously...just for getting out of bed, they will give you this 20% deduction. Better yet, even if you decide to stay in bed, you still get the deduction. That example is admittedly an extreme simplification, but it sets forth the general idea.
However, as personal taxable income levels rise about $315k, the ability to take the deduction becomes much more restrictive. First and foremost, any trade or business involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services DOES NOT GET the deduction once the $315k ($157k if single) income threshold is crossed (there is a small phase out range so that the deduction doesn't go from 20% to 0% immediately). Additionally, any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees does not get the deduction once the $315k threshold is hit. Good luck explaining that clause as no one knows what that means...we all just have our guesses. We are assuming additional guidance will be provided further defining what this means. if guidance is not provided, the application of this rule will result in chaos.
If you're lucky enough, from a tax perspective, to not be in one of the listed 'service' professions and if you don't fall into that poorly written and ill-defined final clause, you are still eligible for the 20% deduction but with restrictions including w2 wage limits as well as some other limits that involve fancy calculations. And we were told that they were simplifying the tax code...amusing. If you are involved in a profession, such as manufacturing, which is perhaps still eligible for the 20% deduction above the $315k income threshold, contact me or your CPA to further discuss to what extent you might be able to capture the deduction.
That's a lot of information so I will wrap this up. Sadly, we have barely scratched the surface on the changes that we are fitting into planning for this year and the years ahead.
Please contact Adam Ditsky at email@example.com to discuss the topics covered here or any other personal tax planning and small business advisory needs.
As a reminder, the content contained within is not meant to act as a substitute for direct advice from a CPA or tax professional. Every situation is different and should be treated as such. Nothing contained within should be construed as advice on your situation.
Adam Ditsky, CPA
President, Ditsky Strategic