2019 Tax Season Update for Individuals and Business Owners

by | Feb 5, 2019 | Tax Consulting

Looking back at 2018, it was certainly a year filled with uncertainty and speculation about the recently enacted tax reform would impact taxpayers. P.L. 115-97, better known as The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017 by President Trump.

While heavily focused on much-needed corporate tax changes designed to make the United States more competitive in the world economy, the TCJA also levied many changes on individuals, impacting both individual taxation and estate taxes. This article will highlight the personal income tax changes that are most widely applicable to our clients.

After reviewing these changes, we will illustrate how taxpayers fitting various client profiles were impacted by the changes (the good, the indifferent, and the ugly).

Finally, we take a closer look at how those changes have reshaped the tax planning landscape going forward—at least until the changes expire at the end of 2025 or interim legislation gets to them sooner.

The basic tax changes.

Tax Rates & Brackets

The TCJA maintained the current system of seven tax brackets (albeit slightly expanded) but lowered the tax rate applicable to income in each of those brackets. Most notably, the top marginal tax rate was reduced by 2.6% to 37%. The following table shows the difference between the two years for married couples. In addition to the rate reductions, please note the expansion of the income thresholds, particularly at the higher marginal tax rates.

 

Personal Exemptions and Standard Deduction

The TCJA completely eliminated taxpayers’ deductions for personal exemptions. Most recently in 2017, filers received a $4,050 deduction for each member of their family. To counter-balance the exemption elimination, the TCJA also imposed the following changes:

  1. A significantly enhanced standard deduction to $12,000 for single filers or $24,000 for married (previously $6,300 and $12,700, respectively).
  2. An expanded Child Tax Credit of $2,000 per qualified child. The credit amount was $1,000 per qualified child in 2017. Eligibility to claim the credit was also greatly enhanced. In 2018, the phase out for the credit begins when taxpayers adjusted gross income reaches $200,000 for single filers or $400,000 for married. In 2017, these thresholds were $75,000 and $110,000, respectively, thus eliminating many middle income taxpayers from realizing a benefit from the credit.
  3. Substantial modifications to the Alternative Minimum Tax (AMT) resulting in its virtual elimination for a large portion of the taxpayers previously subjected to it.

 

Case Study 1 – The Good Consider a taxpayer with the following fact pattern:

  • Married with three children; Florida residents
  • Spouse earning $250,000 per year
  • No investment income
  • Claiming standard deduction
The detailed tax changes.

While the application of the basic changes noted above yields tremendous tax savings to a relatively straightforward situation, the TCJA also significantly changed certain above-the-line deductions and itemized deductions more widely applicable to high income individuals with more complex tax situations.

The following are a comparison of the major changes in itemized deductions from 2017 to 2018.

 

Additionally, the above-the-line deduction for moving expenses has been eliminated (except for active-duty members of the armed forces). The deduction for alimony expenses has also been eliminated for agreements executed after December 31, 2018.

When we analyze the impact of these changes, the results aren’t nearly as favorable as they were for the taxpayer with the basic situation that we analyzed previously.

 

Case Study 2 – The Indifferent

Consider a taxpayer with the following fact pattern:

  • Married taxpayers with three children; New York residents
  • Spouse earning $600,000 per year
  • Charitable donations of $10,000
  • Mortgage balance of $1.5MM and interest paid of $74,000
  • Property Taxes of $30,000
  • Investment & Tax Fees $35,000
  • State income tax deduction of $37,000

 

Finally, when we introduce the following changes to our assumption, the taxpayer starts to become worse off as a result of the TCJA changes. This is primarily because of the substantial tax benefit that they no longer receive for state and local taxes and miscellaneous itemized deductions. In prior tax years the taxpayer received a benefit from these deductions as their high income drove up their effective tax rate and kept them out of the alternative minimum tax despite the add backs.

 

Case Study 3 – The “Kind of” Ugly

Consider a taxpayer with the following fact pattern, modified from the previous example:

  • Married taxpayers with three children; New York residents
  • Spouse earning $2,000,000 per year
  • Dividends of $60,000 (½ qualified and ½ nonqualified)
  • Capital gain distributions of $50,000
  • Charitable donations of $10,000
  • Mortgage balance of $1.5MM and interest paid of $74,000
  • Property Taxes of $30,000
  • Investment and tax fees of $100,000
  • State income tax deduction of $144,000


Qualified Business Income Deduction

A significant focus of the TCJA was much needed corporate tax reform. Prior to 2018, the United States had one the highest corporate tax rates in the developed world. The reduction from 35% to 21% puts the U.S. on much more even footing with our counterparts around the world.

The U.S. economy is driven by many small and medium sized businesses in addition to our large corporations. These businesses are often organized as partnerships, LLCs and sole proprietorships, where income is not taxed at a corporate level but instead passed through to the owners. The Qualified Business Income (“QBI”) Deduction was enacted to effectively reduce the tax rate on passthrough income to owners by up to 20%, putting the tax rate on such income more in line with the corporate tax rate. For example, if a business owner had qualified passthrough income that would ordinarily be taxed at the highest marginal tax rate of 37%, the QBI deduction can reduce the rate on that income to closer to 30%. Although this is still higher than the 21% corporate tax rate, the 20% reduction is a significant decrease to the owners’ effective tax rate on the passthrough income. Owners whose income is taxed at lower marginal rates will get closer to that 21% corporate rate.

For 2018, after $147,500 of taxable income for single filers and $315,000 for married, the QBI deduction is subject to a variety of limitations based on the type of business, the wages paid by and the basis of property that is placed into service by the qualified business.

Income tax planning after the TCJA.

With the elimination of personal exemptions and many itemized deductions, coupled with the expansion of the standard deduction and virtual elimination of the alternative minimum tax, income tax planning has become centered on the following strategies for individuals.

  • Itemized Deduction Bunching – To the extent itemized deductions can be pushed into or “bunched” in a year where the taxpayer is over the standard deduction threshold, a tax benefit can be realized for the outlay of those expenditures (i.e., medical expenses, charitable donations, income and property taxes). This avoids the tax benefit from those items being partially lost in years where the standard deduction in marginally more beneficial and maximizes the “free” tax benefit from the standard deduction in years in which it is claimed.
  • AGI Management – Since many itemized deductions have been curtailed as a result of the TCJA, in order to achieve tax savings and perhaps receive a tax benefit from other deductions and credits that are subject to adjusted gross income limitations, taxpayers must become more savvy in managing their taxable income. In order to do so, taxpayers can better plan for the effectiveness of pretax deductions such as retirement plan and HSA contributions, the use of Qualified Charitable Distributions for their donations and the recognition of taxable income, through earnings management or tax efficient investment and withdrawal strategies.

For entrepreneurs and business owners, income tax planning will also focus on the following planning opportunities:

  • Section 199A Qualified Business Income Deduction – As previously discussed, the TCJA put into place an up to 20% deduction of QBI for business owners taxed as pass-through entities. For taxpayers with QBI under or near the income thresholds of $321,400 (married filing jointly) or $160,700 (single) for 2019, tax planning will be important to limit their exposure of the phase-out thresholds. Planning becomes even more important if they don’t otherwise qualify for the QBI deduction because of the nature of their business or if they would be severely limited in their deduction because of the wages paid and property used factors used in the computation. Owners with qualified businesses over the income threshold will be focused on maximizing their QBI deduction through the management of the wage and property basis factors.
  • Qualified Small Business Stock Gain Exclusion – For business owners meeting certain stock, asset and business requirements who have a liquidity event on the horizon, management of their existing or converted C-Corporation to achieve a 100% exclusion (subject to certain limitations) of the capital gain recognized on the sale of their business under Section 1202 has become a tremendous tax planning opportunity. The reduction of the C-Corporation tax rate to 21% has breathed new life into this long-standing section of the tax code even despite the continuing tax inefficiency from the double taxation aspect of C-Corporations when dividends are paid out to owners. Business owners otherwise fitting the profile for qualification for the QSBS 100% capital gain exclusion may find the short-term C-Corporation income tax inefficiencies acceptable when evaluating the totality of their tax situation after the full exclusion of the gain.

Summary.

The tax planning landscape for individual taxpayers and those with pass-through business income has been significantly changed by the TCJA. While many deductions have been taken away or eliminated, you can see through our example case studies that many taxpayers will be better off or in close to the same tax situation as before moving forward a result of the lower tax rates, expanded tax brackets and curtailment of the Alternative Minimum Tax. The “ugly” for most taxpayers will just be “kind of ugly”. Additionally, the Section 199A 20% QBI Deduction and new life of the Section 1202 Qualified Small Business Stock 100% gain exclusion may yield tremendous tax savings when properly planned for.

We look forward to guiding our Sanderson Wealth Management clients through these changes and helping them realize savings that will help them achieve their estate and wealth planning goals.