Co-written by Alyssa Razook Wan and Oscar Grisales-Racini
The new tax law is lengthy and full of complex provisions. This article highlights three key aspects of the tax reform and how they may affect you.
1. The individual income tax rates have decreased and standard deduction increased, but am I better off?
The individual income tax rates have decreased, with the top rate at 37% as opposed to 39.6% under the prior law, and the standard deduction has increased to $24,000 for married individuals filing jointly, $18,000 for head of household filers and $12,000 for all other filers.
However other factors affect your effective tax rate. The personal exemption is suspended, the personal casualty and theft losses are suspended (except for personal casualty losses incurred in a federally declared disaster area), the state and local tax deduction is limited to a $10,000 itemized deduction (unless paid in carrying on a trade or business) and the mortgage deduction is limited to underlying debt of up to $750,000, to name a few. Therefore, while many individuals will see a decrease in their overall tax bill, there are some individuals and families who may see an increase as a result of these changes.
It is important to keep in mind that all of the above tax law changes are set to expire December 31, 2025, and barring any contravening legislation, the tax law will revert to the prior law on January 1, 2026.
2. Is it more advantageous to organize as a corporation or pass-thru entity?
Organizing as a corporation seems more appealing these days, as the corporate income tax rate has been reduced to a flat 21%, down from a maximum federal rate of 35%. Income earned from pass-thru entities are subject to tax at the progressive income tax rate schedule with a maximum rate of 37% but are generally eligible for a 20% deduction, subject to limitations and exclusions based upon income thresholds and whether the entity is a service or non-service business, resulting in a maximum effective rate inclusive of the deduction of 29.6%. The decreased corporate rate is not set to sunset, although the pass-thru deduction is generally effective January 1, 2018 to December 31, 2025.
However, from the perspective of a shareholder, the “true” effective corporate tax rate must account for the second level of taxation that occurs when the corporation makes a distribution to its shareholders. The shareholder may pay up to 20% dividend tax plus a 3.8% net investment income tax, resulting an effective corporate and shareholder tax rate of 39.8%.
Certain benefits arise from the corporate form that are not available to a pass-thru entity, such as deferral of the shareholder level tax. Additionally, depending on the income and type of the business, the pass-thru deduction may be unavailable or limited to an amount that is less than 20%. Therefore, choosing the most tax advantageous entity that fits your circumstances requires a careful review of the specific tax and non-tax goals of your business.
3. What actions should I take in light of the increased gift and estate tax exemption?
The estate and gift tax exemption, also referred to as the “unified credit,” has doubled to approximately $11.2 million for individuals and $22.4 for married couples for the year 2018, and are set to be adjusted annually for inflation. Barring future legislation, the exemption amounts will return to 2017 levels beginning January 1, 2026. The annual exclusion has increased to $15,000 per person. The estate and gift taxation rates have not changed, and the maximum rate is 40% for a value of $1,000,000 or greater.
Taxpayers with large estates may take this opportunity to forgive or cancel promissory notes or make large gifts to self-settled or other irrevocable trusts in order to reduce their estates by the value of the gifted estates as well as any future growth expected from such assets. Additionally, it may be advantageous to make a late allocation of generation-skipping transfer tax to existing irrevocable trusts.
Even if your estate is below the new exempted amount, it is still worthwhile to review your estate plan with your advisor. Credit shelter trusts may receive more assets than it was anticipated the trusts would receive when they were formed, and it is important to understand the disposition of trust property under the new law.
DISCLAIMER. The foregoing summary is for general educational and information purposes, is not legal advice and does not present a detailed or complete presentation of the new tax law. Each case is unique and requires a careful analysis by one's advisor of the specific facts and circumstances in order to arrive to appropriate advice.