As the year comes to a close, it is important to evaluate your year-end tax planning strategies. In addition to referencing this guide during tax planning season, it can also be a helpful year-round tool. Active involvement in these and other underlying areas of tax planning help to put you in a better position to preserve and generate longer-term wealth for you and your family.
The effect of 2017 tax reform changes continue
In December 2017, the U.S. government officially enacted new tax legislation, known as the Tax Cuts and Jobs Act (TCJA), which generated significant changes to the income tax and transfer tax laws for 2018 and thereafter. While most of the corporate provisions are permanent, many of the individual changes are scheduled to expire after 2025. New developments from the TCJA are continuing to arise in 2019.
Lower Individual Income Tax Rates and Revised Brackets
Similar to 2018, this year brings adjustments to the tax brackets and limitations. However, the change is less dramatic than the previous year.
For instance, the threshold for the maximum tax bracket of 37% increased from $600,001 (MFJ) in 2018 to $612,351 (MFJ) in 2019. There are similar increases across the board. Also of note – starting in 2019, the Chained Consumer Price Index (C-CPI) will be used for indexing in lieu of the Consumer Price Index (CPI).
New Limits on Itemized Deductions
In 2018 we saw the standard deduction nearly double compared to 2017. This year the upward trend continues.
Due to the increased standard deduction, fewer taxpayers will itemize their deductions. One option to consider is itemizing your deductions every other year, accelerating or postponing them in order to “bunch” more itemized deductions together in a particular year.
In addition to the increased standard deduction, in states with higher income tax rates there is a new limit of $10,000 for state and local taxes. However, this limit does not apply to taxes incurred through a trade or business or for the production of income.
Another note in regards to deductions is the “home equity indebtedness.” Under the new law, an itemized deduction for a home loan is typically reserved for mortgages under $750,000 or $1,000,000 if the home loan was in place by December 15, 2017. While home equity indebtedness may not be deductible as home mortgage interest, there is an exception when such debt is used to buy, build, or substantially improve the home, and the home secures the debt. Compared to 2017, the rules have become far more strict.
Alternative Minimum Tax
The alternative minimum tax (AMT) is there to make sure that taxpayers using deductions, credits and other exclusions to reduce their tax liability still pay a minimum amount of tax. Recent changes kept the AMT for individuals while repealing it for corporate taxpayers. However, there are elevated exemption and phase-out thresholds. This increase leaves room for some relief for individuals. In this case, a tax projection can help you determine whether you are likely to owe the AMT for 2019. In the event that you are, there may be viable tax strategies to mitigate the impact of the tax.
The TCJA effectively doubles the combined gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption. For you, this means new estate planning opportunities to consider. In 2019 the exemption increases to $11.4 million per individual (compared to $11.18 million in 2018). After 2025 the exemption reverts back to $5 million.
Also keep in mind that the gift and estate tax exemptions remain unified so any use of the gift tax exemption during the taxpayer’s lifetime decreases the estate tax exemption available at death. The tax rate for all three taxes remains at 40%.
The changes have also made funding a 529 education savings plan for your child or grandchild an even more attractive option. Distributions from 529 plans used to pay qualifying education expenses are generally tax-free. The definition of qualified education expenses has been expanded to include not just postsecondary school expenses, but also primary and secondary school expenses. However, primary and secondary school expenses are limited to $10,000 annually. This change is permanent. Fund the 529 Plan while the kids are young in order to capitalize on the tax free growth.
Gifting appreciated securities to children may also make sense if the children are in the bottom two tax brackets (for singles, taxable income of less than $39,475). The tax rate on long-term capital gains and qualified dividends is 0% for taxpayers in the 10% or 12% tax bracket. If your child is under 24, watch out for the “kiddie tax” rules.
Unreimbursed Medical Expense Deduction
Unreimbursed medical expenses are still deductible, regardless of age. However, in 2019 they qualify as itemized deductions to the extent that they exceed 10% of your adjusted gross income (AGI). This represents an increase from 7.5% in 2018.
Alimony for Divorce
Alimony is essentially an amount paid by a person to a spouse or former spouse under a divorce or separation agreement.
Under the new law, alimony payments are no longer deductible and will no longer be included in the recipient’s taxable income. This new alimony treatment is set for divorce agreements executed, or even modified, after December 31, 2018. Divorce agreements issued prior to January 1, 2019, the old rules remain intact.
The new rule could increase the overall tax burden on the total income of the two spouses, and will mean the alimony calculations may need to be reconsidered. Payment of alimony will be more expensive because the payment will be made from after-tax rather than the pre-tax dollars. Conversely, the receiving spouse will not have to consider taxation when determining the spending power of the amount received.
If you are paying alimony, carefully review your situation to ensure that you achieve the most desirable tax consequences. You may need to modify agreements to re-characterize payments or make certain elections. In addition, not all states have adopted the federal tax rule for post-2018 settlements. Consult with your tax advisor and attorney to confirm your state tax obligations.
The special 20% deduction on qualified business income (QBI) is a great tax planning opportunity. But it is important to keep in mind that there are certain criteria and limitations to obtain the full benefit. The deduction typically applies to income from pass-through entities, like S Corporations and LLCs, as well as sole proprietorships (Schedule C). However, personal service businesses will not qualify unless an individual’s taxable income is below certain thresholds.
Individuals with taxable income below certain thresholds ($157,500 for singles and $315,000 for married filing joint) will not be subject to the personal service income limitation or the wage and/or depreciable property limitation. Thus, under these circumstances, a personal service business is eligible for the 20% QBI deduction. As you strategize, keep taxable income below these thresholds, at least every other year, by shifting income and expenses between years. The requirement to have a certain level of wages and/or a certain level of depreciable property makes it difficult to maximize the 20% deduction once an individual’s income is above the threshold amount. For those who are managing the pass-through entity, this requires planning and analysis prior to year-end to maximize the income eligible for the deduction. Generally, each pass-through business entity flowing into your individual return requires separate analysis. This increases the cost of preparing tax returns. Another benefit of the Section 199A deduction is that QBI generally includes passive investments in real estate (watch out for NNN leases), REIT’s and PTP’s. However, QBI does not include capital gains from these investments.
Tax planning to optimize the 199A deduction will be challenging. If you achieve a full 20% deduction on QBI, your effective federal tax rate on business income will be reduced to no more than 29.6%. It will be important to discuss planning with your tax advisor before year-end so as to maximize qualified business income and the 20% deduction. The issues that need to be addressed are significant! One example is that you will want to minimize wages paid to you by your qualified business entity, but not so much as to trigger a reduction in the 199A deduction for insufficient wages.
Also, be aware that moves designed to reduce this year’s taxable income (such as postponing revenue or accelerating expenses) can inadvertently reduce your QBI deduction. Work with your tax advisor to anticipate any adverse side effects of other tax planning strategies and optimize your results on this year’s return.
Sec. 179 and Bonus Depreciation
Thanks to the TCJA, 100% first-year bonus depreciation is available for qualified new and used property that’s acquired and placed in service in calendar year 2019. This means your business might be able to write off the entire cost of some (or all) of your 2019 asset additions on this year’s return. A year-end purchase of equipment could substantially reduce your taxable income. This may be a good tool to reduce your taxable income below the $315,000/$157,500 threshold so as to maximize the 199A deduction.
Bonus depreciation isn’t subject to any spending limits or income-based phase-out thresholds, but the programs will be gradually phased out, starting in 2023, unless Congress extends it. Consider buying extra equipment, furniture, computers or other fixed assets before year-end. Your tax advisor can explain what types of assets qualify for this break.
Heavy SUV’s, pickups and vans that are used over 50% of the time for business are treated as transportation equipment for tax purposes. So, they generally qualify for 100% bonus depreciation.
For qualifying property, the TCJA increased the maximum Sec. 179 deduction to $1 million in 2018. This number has further increased in 2019 to $1,020,000 with an investment ceiling of $2,550,000. (Under prior law, the limit was $510,000 for tax years beginning in 2017.)
The Section 179 deduction has also expanded to include personal property used to furnish lodging and certain real property, including improvements to an interior portion of a nonresidential building.
Starting a new business is an expensive undertaking. If you are involved in a new business venture in 2019, you may elect up to $5,000 of your business start-up expenditures, such as travel expenses incurred lining up prospective distributors and advertising costs paid or incurred before the new business began operating. In order to claim the deduction for 2019, your business must be up and running by year-end.
More Notable Business Changes
There is an important limitation on individual business losses. Note that individuals with a business loss of $250,000 (or $500,000 for MFJ), they cannot currently deduct the loss. Instead you must consider it part of your net operating loss carryover. Net operating losses carried forward are limited to 80% of taxable income.
In addition, business memberships for entertainment, recreation, or social purposes are no longer deductible. You still have the ability to deduct other memberships as long as the main purpose does not include providing entertainment or entertainment facilities for members or their guests.
The TCJA has also made it easier for businesses with gross receipts of less than $25 million to continue the cash method of accounting. It is also easier for these small businesses to avoid or minimize what may otherwise be capitalized as inventory costs. Please see your advisor for details.