2017 End-of-Year Tax Planning
(And the Impact of the Pending Tax Cuts and Jobs Act)
Tax planning primarily involves applying a taxpayer’s facts to the current and future tax laws to determine the best outcome, and providing advice regarding how to achieve that outcome. When tax rules are similar in the current and following year, this often involves deferring income and accelerating expenses, to take advantage of the time value of the deferred taxes. However, when different tax rates or treatments apply to the two years, permanent tax savings often can be achieved with proper planning.
It has been unusually difficult this year to provide meaningful advice because Congress has been working on, but has not finalized, what very likely will be the most significant changes in federal tax rules that we have seen in over 30 years. We have seen competing proposals from the House and Senate in recent weeks, but on Friday evening, we finally saw proposed legislative text that was approved by a committee charged with merging House and Senate plans into one. The House and Senate will vote on the resulting conference agreement this week (known as the Tax Cuts and Jobs Act) and members of Congress claim to have sufficient votes to allow the bill to pass.
- Observation: It would be nice if law changes like this were resolved in the middle of a year, allowing time to plan and react long before the changes apply. We certainly were hopeful we would know the outcome of Washington’s efforts long before now, as we were led to believe would be the case multiple times. Instead, here we are again, watching Congress, with its delay, figuratively take a shovel to the reindeer stalls to fill up tax accountants’ Christmas stockings.
This alert does not pretend to be a complete overview of the proposed law, but will cover some of the more common provisions, and explain how they may impact your last-minute tax maneuvers.
Our lawmakers gleefully tout the fact that the standard deduction has been nearly doubled in the proposal. They are a bit more subdued in allowing us to quietly discover that exemptions (currently around $4,000 per family member) will completely disappear. The proposed standard deduction amounts are $24,000, $18,000, and $12,000 for married joint filers, head-of-household filers, and all other filers, respectively.
Many itemized deductions will be eliminated or limited under the conference agreement. This means that far fewer individuals will use itemized deductions in the future, because the surviving itemized deductions will not exceed the increased standard deduction. Those who are in that category should consider accelerating some itemized deductions into 2017.
Also, the proposal calls for lower individual tax rates at many income levels beginning in 2018. The combination of the rate changes and expiration of many itemized deductions suggest that the acceleration of deductions and deferral of income that represent common tax planning tools in most years takes on an added significance this year. Lowering income in 2017 could result in permanent savings, rather than merely paying the tax a year later.
- Observation: Taxpayers whose itemized deductions generally exceed the proposed standard deductions, but not by a wide margin, should consider whether careful “bunching” of expenses would allow them to itemize every other year. For example, if cash flow allows, consider making charitable contributions that ordinarily are spread over two years instead in one year, and timing other expenditures, like real estate tax, to occur in the same year. This could result in alternating between itemized and standard deductions, with the outcome being lower taxes in each two-year period – all due to timing, without incurring any additional expense.
State and local taxes
State and local taxes join charitable contributions, medical expenses, and mortgage interest as some of the few surviving itemized deductions. However, significant new restrictions will apply.
State and local taxes include real estate tax, personal property tax (such as the excise tax paid when registering a vehicle), and income taxes paid to a state, county, or municipality. Beginning in 2018, these outlays collectively are limited to a deduction no greater than $10,000, regardless of filing status. However, business-related taxes in these categories will continue to be unaffected by this cap, generally remaining deductible on Schedule C, E, or F rather than Schedule A.
- Observation: New Hampshire’s Business Profits Tax, even when incurred by a sole proprietor, is not considered to be a state income tax for this purpose. It is deducted in arriving at Adjusted Gross Income (“AGI”), rather than as an itemized deduction. As such, this tax appears likely to remain deductible in spite of the proposal in Congress.
State and local income taxes offer more limited year-end planning opportunities than real estate and personal property taxes. Prepayment of real estate tax and personal property tax in 2017 may generate a valid itemized deduction in 2017, as long as such payments are made “in good faith,” a phrase that is vague and fact-specific. State and local income taxes, meanwhile, are the subject of specific language in the new rules that limits the 2017 deduction associated with any prepayment to the amount of tax actually imposed as part of a taxpayer’s 2017 liability – an amount that will not be known with precision until 2017 tax returns are filed.
- Commentary: Underestimating 2017 state and local tax may result in missed deductions, but over-estimating (or deliberately paying excessive tax) will not yield additional deductions.
Note that this deduction will not be helpful if Alternative Minimum Tax (“AMT”) applies to you in 2017, because taxes are not deductible in computing income subject to that tax.
Mortgage, home equity, and investment interest
The bill eliminates deductions for interest on a home equity loan. It preserves mortgage interest on a primary and secondary residence, but lowers the loan cap to $750,000 ($375,000 if married filing separately). The limitations will apply to both new and existing loans. Prepaying a loan payment this year may be helpful, but the deduction will be relatively modest because interest generally is computed monthly, and any excess will be applied to principal.
The bill calls for contributions to survive as an itemized deduction, and it increases the percentage of income that can be offset with cash contributions to public charities from 50% of AGI to 60%. This outlay, more than perhaps any other itemized deduction, is discretionary, and lends itself well to the perfectly legitimate scheme of “bunching” itemized deductions discussed above.
Although the deductibility of charitable contributions is expected to survive Washington’s current efforts, the loss of so many other types of itemized deductions means that for many people, donations may not alter a person’s tax beginning in 2018. This suggests that frontloading contributions into 2017 may be prudent. For those who are inclined to give significant amounts to charity each year, but will still fall below the standard deduction thresholds, establishing and contributing to a donor-advised fund by the end of this month may be worth looking into.
If possible, consider donating appreciated securities rather than cash. Transfer of securities potentially allows a deduction equal to the market value of those holdings, while simultaneously allowing any long-term gain (the difference between market value and cost basis, for securities held longer than one year) to permanently be excluded from your income. Note that the securities must be transferred directly to the charitable organization; by contrast, your sale of the securities followed by remitting the resulting cash to the charity will not allow you to sidestep the taxable gain.
Miscellaneous itemized deductions
The agreement repeals a number of miscellaneous itemized deductions. Many taxpayers see no tax benefit from these expenses because they are deductible only to the extent they collectively exceed 2% of AGI. However, those who do receive a deduction may benefit from accelerating payment of these expenses into 2017 while they still exist. Examples include unreimbursed employee business, expenses to produce income (such as investment management fees), costs of tax preparation services, costs of a home office, and many others.
Medical costs is one area where the upper chamber and the lower chamber of Congress addressed the issue, but took completely opposite approaches. The House wanted to repeal this deduction, and the Senate wanted to expand it. The conference agreement retains the deduction, and in fact lowers the threshold of deductibility from 10% of AGI to 7.5% for taxpayers of all ages (currently 7.5% applies only to those aged 65 or older, and 10% applies to all others). This change will allow more taxpayers to benefit from the deduction. It further proposes this reduction be favorably applied retroactively to the beginning of 2017. Taxpayers who will itemize this year but not next may benefit from prepaying as much as possible before the end of this year.
Generally – defer income, accelerate deductions
Similar to individual provisions, the bill calls for a reduction to business taxes. For taxable C-corporations, this involves a reduction in the top rate from 35% to 21%, effective for years beginning in 2018. For pass-through entities (partnerships, LLCs and S-corporations), it subjects the income to the owner’s regular tax brackets, but after allowing a deduction of up to 20% of the pass-through income. For higher-income taxpayers, additional limitations encourage businesses to carry large payroll costs and deny the deduction for “specified services” providers, such as doctors, attorneys, accountants, brokers, financial advisors, and athletes.
- Observation: Regardless of the varying details, it seems clear that Congress intends to lower taxes on most businesses. This suggests that this year, more than ever, it makes sense to reduce or defer taxable income and accelerate deductions, because doing so may create permanent tax savings.
Business equipment expensing
Current “bonus depreciation” rules allow 50% of the cost of certain equipment to be deducted in year 1, with the balance depreciated over the appropriate tax life. For 2018 and 2019 that becomes 40% and 30% before disappearing. The proposed law is more generous, allowing 100% beginning with assets acquired and placed in service beginning 9/28/17 and ending after 2022 (longer for certain property). It also removes the long-standing requirement that the original use of the assets must commence with the taxpayer, allowing both “used” and “new” assets to qualify.
With the conference agreement, the similar, but separate, Section 179 expense is scheduled to increase beginning 1/1/18 from the current $510,000 maximum deduction to $1,000,000. The phase-out threshold would increase from $2,030,000 to $2,500,000. This increase would remain permanent, and be indexed for inflation. It also would allow Qualified Improvement Property, HVAC, fire protection, security systems, and roofs to qualify, beginning with additions placed in service after 12/31/17.
The bill would also increase the deduction cap on passenger vehicle depreciation, effective for property placed in service after 2017.
There are very few retroactive provisions in the bill, but some of them are found in this category. When it comes to depreciation, generally any planning involves mere timing of the deduction, because regardless of methods or limits, in the end every path (with very few exceptions) leads to deduction of no more (and no less) than 100% of the cost. However, if rates decrease next year, businesses that accelerate qualifying fixed asset additions into 2017 will permanently benefit from decreased taxes, by taking the deduction in a year with higher rates.
Interest expense limitation
Generally the bill proposes capping business interest expense deductions to 30% of an entity’s income beginning after 2017, subject to a number of complex modifications and exceptions. The limitation will apply to all forms of businesses, including C-corporations and pass-through entities, but will not apply to any taxpayer with average annual gross receipts of $15,000,000 or less. It will apply regardless of when the loan was initiated. Certain real estate and farming businesses will have the option of electing out of this limitation, but only if a less beneficial method of asset depreciation is paired with it.
Entities that are rather heavily leveraged, or will be if more debt is incurred, will have a much more difficult time computing the “net of tax” cost of existing or new debt service. Interest disallowed may be carried forward for deduction in future years, under the proposal.
- Observation: Mention of this provision is somewhat out of place in a discussion of year-end planning, because there is little that can be done to modify the outcome. However, it is relevant to ongoing budgeting for the upcoming year, and prepayment of the next debt payment, although much will merely offset principal, may yield some additional interest deductions that might be capped in the future.
The next steps for this tax bill involve votes in the full House and the Senate later this week. Any surprises encountered there would not be the first we have seen this year, so in spite of committee members’ beliefs that they have the votes to approve this, we have no assurance that we truly know which tax laws will apply to us just a few short days from now (and some of the bill’s features will kick in retroactively to dates weeks or months ago). It has been frustrating to wait this long to only be “somewhat confident” of the upcoming tax treatment – as opposed to knowing it.
- Observation: We probably can all agree that if the tax legislation that applies on New Year’s Day is not rolled out long enough in advance for a carton of eggnog placed in the fridge on that very day to turn bad before New Year’s Eve, Congress has failed us.
Nevertheless, we hope these tips are helpful to your last-minute tax planning.
If you have any questions regarding year-end tax planning, please contact your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.