Colorado Probate Blog - Wade Ash Woods Hill & Farley, P.C.

11 minutes reading time (2106 words)

Tax Update

This Tax Update article is authored by Laurie A. Hunter, Kevin D. Millard, Jonathan F. Haskell and Heidi J. Gassman.

Estate and Gift Tax Provisions (These changes sunset after December 31, 2025.)

The Tax Act doubled the gift, estate, and generation-skipping transfer tax exemptions from $5 million (as indexed for inflation since 2011) to $10 million per U.S. citizen and U.S. resident taxpayer (also indexed for inflation since 2011).

This increased the gift, estate, and GST exemptions from $5,490,000 in 2017 to approximately $11.2 million in 2018. This change will affect formula provisions in wills and trusts that divide between a credit shelter share and a marital share. If your documents use such formulas, you should consider whether changes should be made to carry out your wishes for your family at your death.

Doubling the exemption also makes additional lifetime gifts possible for taxpayers who had already used most, if not all, of their $5 million gift exemption. If you have assets that you expect will appreciate, then you may want to make a gift to use your increased exemption, especially because the increase will sunset after 2025. The tax rate on gifts or estates in excess of the exemption remained at 40%. Of course, you need to consider the effect on basis of the gifted assets. While no change was made to the “step up (or down)” in basis to fair market value at date of death for assets in an estate, a donee of a gift takes a carryover basis (the donor’s basis) but, for purposes of determining loss, the donee’s basis is limited to the fair market value on the date of the gift.

The gift tax annual exclusion was not changed but, because of inflation, increased to $15,000 for 2018 over $14,000 in 2017.

Individual Income Tax Provisions (These changes sunset after December 31, 2025.)

The individual standard deduction was nearly doubled to $24,000 for married filing jointly, and $12,000 for single taxpayers. The income tax rates are slightly reduced. However, the deduction for personal exemptions was eliminated. Many itemized deductions for individuals were eliminated or reduced, including:

  • $10,000 limit ($5,000 for a married taxpayer filing separately) on the deduction for state and local taxes (including state income taxes and real property taxes).
  • No deduction for interest on home equity loans, including current HELOCs, except for amounts used for home improvements, subject to the overall limit of $750,000.
  • The deduction for mortgage interest on new loans is allowed for up to $750,000 in acquisition indebtedness (down from $1 million).
  • No deduction for alimony in divorces finalized after 12/31/2018 (and the receipt of alimony will no longer be taxable income).
  • Medical expenses may still be deducted over 7.5% of AGI in 2018 and 2019, and 10% of AGI 2020 through 2025.
  • No miscellaneous itemized deductions, including investment advisor fees, accountant’s fees, and attorney’s fees for tax advice.
  • Charitable contributions may still be deducted, and the limit for cash contributions to public charities is increased from 50% of AGI to 60% of AGI.
  • Net operating losses are disallowed for the current year, but may be deducted in a future year up to 80% of taxable income. Farms may carry back NOLs for two prior years.

The Child Tax Credit is increased to $2,000 per qualifying child from $1,000, and there is a maximum refundable credit of $1,400 per qualifying child. The credit is phased out for taxpayers with AGI in excess of $200,000 or $400,000 for joint filers.

529 plan accounts were modified to allow distributions of up to $10,000 for elementary and secondary school tuition. However, action must be taken at the state level to change the state statutes to permit such tuition payments. College Invest sent out a notice that these tuition payments may not be considered “qualified” under Colorado’s current 529 plan statutes. Competing bills have been introduced in the Colorado legislature, one allowing the new payments, and the other prohibiting them.

The Alternative Minimum Tax (AMT) exemptions are increased from $54,300 to $70,300 for single taxpayers and from $84,500 to $109,400 for married filing jointly. The threshold at which the AMT exemption begins to phase out is increased from $160,900 to $1 million for married filing jointly, and from $120,700 to $500,000 for single taxpayers.

Conversions of traditional IRAs to Roth IRAs will no longer be able to be reversed. Under prior law, the conversion could be reversed until the extended due date of the individual’s tax return for the conversion year.

The “Kiddie Tax” will now use the estate and trust tax rates instead of the parents’ rates. The Kiddie Tax is on unearned income of minor children.

Estate and Trust Fiduciary Income Tax (These changes sunset after December 31, 2025.)

  • The tax rates for estates and trusts are slightly reduced. The AMT is not modified for estates and trusts.
  • Miscellaneous itemized deductions subject to the 2% floor are not deductible (same as the change for individuals).
  • Itemized deductions not subject to the 2% floor are deductible. These include trustee fees, attorney fees to administer the trust or estate, preparation of estate tax returns and fiduciary income tax returns (but not gift tax returns), and administrative expenses such as probate filing fees, appraisals, and preparation of accountings.
  • State and local taxes up to $10,000 are deductible
  • Charitable contributions are deductible if required by the governing instrument and otherwise meet the requirements under prior law.
  • Trusts and estates still have the personal exemption deduction ($600 for estates, $100 for simple trusts and $300 for complex trusts).

Qualified Business Income Deduction (These changes sunset after December 31, 2025.)

The Tax Act creates a new Internal Revenue Code Section 199A that allows individuals to deduct up to 20% of “qualified business income” from sole proprietorships, partnerships, limited liability companies, and S corporations (“pass-through entities”). This deduction is also available to trusts and estates. The new provision is extremely complex, and the following is only a general overview of the provision.

In general, “qualified business income” is income from an active trade or business, but certain specified service businesses are generally excluded: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees. As discussed below, the exception for certain service businesses does not apply to taxpayers whose income is below a threshold amount.

The deduction equals (1) the lesser of (a) the taxpayer’s combined qualified business income, or (b) 20% of taxable income (reduced by any net capital gain and qualified cooperative dividends), plus (2) the lesser of 20% of qualified cooperative dividends or taxable income (reduced by net capital gain). After applying that complicated formula, the deduction may not exceed taxable income (reduced by net capital gain).

The deduction reduces taxable income. It does not reduce adjusted gross income. This means that a taxpayer may take the deduction even if the taxpayer does not itemize and also takes the standard deduction.

There is a threshold amount that affects both whether a lower-income taxpayer can take the deduction with respect to income from one of the specified services businesses that are generally excluded from the deduction, and the amount of the deduction for higher-income taxpayers. The threshold amount is $157,500, or $315,000 for taxpayers filing a joint return. These amounts will be adjusted for inflation beginning in 2019.

A taxpayer whose income does not exceed the threshold amount may take the deduction even if the income is from one of the specified services businesses, but the deduction phases out ratably as the taxpayer’s taxable income exceeds the threshold amount plus $50,000 ($100,000 for a joint return). For a higher-income taxpayer, the deductible amount cannot exceed the greater of (1) 50% of W-2 wages from the business, or (2) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. A taxpayer’s “W-2 wages” generally means the amount of wages and deferred compensation received by the taxpayer that are attributable to qualified business income. “Qualified property” generally means tangible property subject to the allowance for depreciation and used in the trade or business.

Some argue that the new flat 21% corporate income-tax rate makes a C corporation a more attractive option than a pass-through entity. Income from C corporations, however, is still subject to taxation at both the corporate and shareholder levels. The effective tax rate on income from a pass-through entity after taking into account the qualified business income deduction may be lower than the combined rate of tax on income from a C Corporation.

C Corporations

One of the biggest impacts the Tax Act has is on the income taxation of C corporations. In a nutshell, the Tax Act (1) permanently reduced the tax rate for C corporations from a top rate of 35% to a flat rate of 21%, (2) permanently repealed the AMT for C corporations, which up until now has been imposed to make corporations pay a certain minimum amount of tax if their regular tax rate is too low, and (3) allowed immediate, up-front deduction of 100% of capital assets purchased by a corporation and placed in service after September 27, 2017, as opposed to depreciating those assets over time.

Historically, C corporations fell out of favor for small businesses with the advent of “pass-through” limited liability entities such as limited partnerships and limited liability companies. Whereas the pass-through entities offer one-time taxation at the tax rate of the owners, C corporation income is taxed twice, first at the level of the corporation itself and then again at the level of the shareholder receiving dividend distributions from the corporation. C corporations, however, are still common at the big business level for a number of reasons (e.g., financing and investment considerations and public offering requirements).

The changes implemented by the Tax Act raise one very big question for many business owners: whether to convert their S corporation, limited liability company, or limited partnership to a C corporation to take advantage of the new, low flat tax rate at the corporate level.

In making such a decision, it is good to remember that while the new corporate tax rate is low, a second “tax bite” will still come out at the individual taxpayer level. However, corporations that do not pay out dividends to shareholders, or that are planning to re-invest most or all of their profits back into the business, may benefit from operating as a C corporation under the new tax law, at least until their business goals or financial needs change over the long run.

Also under the Tax Act, certain businesses operating as pass-through entities may deduct up to 20% of “qualified business income,” that is, income from an active trade or business, subject to complex rules and restrictions. This means that the effective tax rate on income from a pass-through entity claiming this deduction may be lower than the combined tax rate imposed on a C corporation. However, above certain income levels ($157,500 for a single filer or $315,000 for joint filers), most service businesses are excluded from claiming this deduction. Therefore, business owners who provide both services and non-service products may wish to consider bifurcating into separate entities, segregating operations that qualify for the 20% deduction into an S corporation or other pass-through entity, and other operations into a C corporation.

Additionally, if you anticipate buying expensive equipment for your business to use (e.g., restaurant equipment or substantial computer/server hardware), you could take advantage of the new 100% expensing rules mentioned above. Be careful, however: the 100% expensing option is only temporary, and is reduced to 80% and below after December 31, 2022 or December 31, 2023, depending on the type of capital property you purchase and when you begin using it.

Ultimately, each business considering changes in entity structure in response to the Tax Act must very carefully examine the nature of its work, the current and predicted distributions of income to shareholders, members, and partners, and the impact of any change on the current ownership structure of the business. As part of this process, business owners should use real numbers to analyze different scenarios, so that they may quantify the potential for tax savings at the level of both the entity and the individual owners as accurately as possible. The only certainty in the process, unfortunately, is that it is not a simple analysis; however, it may well be worth it in the long run. We recommend that you talk to your tax advisor about your own choice of business entity.

March Comes in Like a Lion for Scams
Overview of 2018 Tax Act

Related Posts