"The U.S. Senate is considering a bill that would tax Botox. When Botox users heard this, they were horrified. Well, I think they were horrified. It's difficult to tell."
- Craig Ferguson
By a vote of 227 - 203 in the House and 51 - 48 in the Senate, the Republicans have just passed the most significant new tax legislation in 20-30 years. Before jumping into the details of the new tax plan, I want to ask that everyone reading this first ask the "why" question. Why is the administration doing this at all? The answer is "to lower corporate tax rates" in the hope of creating more jobs and generating more corporate tax revenue. You have to recognize that the highest marginal corporate tax rate in America, practically speaking anyway, is 35%. That is the 4th highest rate in the world (the highest being 55% in the United Arab Emirates). Now, just because we have such a high marginal tax rate does NOT mean that every corporation in America is paying taxes at the level. What is the AVERAGE tax rate of American corporations? According to the Tax Foundation, that rate is 24.71%. A tax rate of ~25% doesn't sound nearly that bad until you realize that the average corporate tax rate in Europe is 18.7%. That 6-point difference in taxes means that American corporations are paying 31% MORE in corporate income taxes than their European counterparts. In China, if you're a technology company, the difference is even greater.
Think about it this way: If you can imagine yourself bypassing your local grocery story and going to Walmart or Target for an item that is 25% less, then you can appreciate the conundrum that corporate CEOs face when managing the relatively uncompetitive "price" of their corporate income tax liability. Few of us are willing to pay more than the lowest price we can find....and none of us want to pay more than a competitive price. US corporate tax rates have been less than competitive for years now.
According to a 2015 Forbes article, corporations have nearly $2.1 trillion in accumulated profits sitting off-shore to avoid US corporate taxes. What the Trump administration is trying to do is to lower the corporate tax rate to create an incentive for those corporations to bring that money back to the US. The administration's view is that it's better to get a lower percentage of something vs. a higher percentage of nothing...in terms of tax revenue. As a result, the new tax plan lowers corporate income tax rates from 35% to 21%. To me, this makes all kinds of sense.
Ok, so what about personal income taxes. Why all the changes here? To make a long story short, the changes in personal taxes are simply the result of the negotiations that made the changes to the corporate rates possible.
What follows is a summary of the big issues as I see them from both a personal and business perspective.
With our political environment being as contentious as it is, there are a lot of questions regarding whether the new tax bill will help or hurt "regular" families. In my view, the answer is largely that it will help. I'm going to take you into the weeds a little bit, so read on.
Under the current rules, everyone has a Standard Deduction AND a Personal Exemption. The Standard Deduction is currently worth $6,350 to you as an individual and $12,700 to you as a married couple. The Personal Exemption is worth $4,050 (in 2017) for each member of the family. If you're a married couple with two children, your total deductions (if you don't "itemize") will be $28,900 for the 2017 tax year.
Under the new tax law, the Standard Deduction and the Personal Deduction are merged together. The new Standard Deduction is $12,000 for individuals and $24,000 for couples.
But wait, you may be thinking...."If I'm a family of 4 and look at the old system, I had $28,900 in deductions. In the new system, I only have $24,000 in deductions. That sounds like my taxes are actually going up!" Like the infomercials you see on TV though, allow me to say "But wait, there's more!"
Under the new tax law, the government is also increasing the Child Tax Credit. Specifically, this credit is increasing from $1,000 per qualifying child (under age 17) to $2,000 per qualifying child. Additionally, the government has created a new Qualified Dependent Tax Credit. These are dependents that are either not under the age of 17 (college-age children) or they might be dependent parents living in your home. For them, there is a $500 tax credit. The income phaseout rules to qualify for these credits are increasing from $75,000 for individuals and $110,000 for married couples to $200,000 for individuals and $400,000 for married couples. All of this is positive.
Net-net, when looking at the give and take between the lower tax rates, the merging of the standard deduction and personal exemption, and the availability of the child/dependent tax credits, most people will see a reduction in their tax bill.
ALTERNATIVE MINIMUM TAX (AMT)
The Trump administration had hoped to eliminate this tax, however with the negotiations that took place that kept other tax deductions viable (mortgage interest deduction, charitable contributions, etc.), this was not possible. Still, AMT under the new law is much more limited than under the old one. In the past, AMT primarily affected those with a taxable income between $150,000 and $600,000. Under the new law, it will be difficult to trigger the AMT unless they are exercising Incentive Stock Options (ISOs).
LIMITATIONS ON DEDUCTIONS
For those that DO itemize their tax deductions, there has been a lot of chatter about the elimination of a number of itemized deductions. For the most part, the horror stories everyone feared didn't happen under the new law, but there are limitations and changes.
IMPACT ON CHILDREN
This is a problem under the new tax law.
When you think of your kids and money, break "money" down into two categories: (1) their earned income, and (2) their unearned income. Earned income is exactly what it sounds like. It's the money they earn while working at the mall, etc. For this income, they are taxed at their own tax rates. Because they probably aren't earning a lot, their tax rate is low...which means their tax liability is low. Both the old and the new tax law work the same way on this point. For unearned income though, things change for the worst. If you or the grandparents have left an investment portfolio for the kids, the income from this money is subject to the "kiddie tax." Under current law, this income is taxed at the parents' tax rate. While not great, it is what it is. Under the new law though, unearned income is taxed as though the income comes from a trust and is taxed at trust tax rates. This means that every dollar of unearned income above $12,500 is taxed at a 37% federal income tax rate under the new law even when the parents are in a lower tax bracket.
There's a fair amount of nuance with this one, so beware and be aware.
While there was A LOT of discussion in the House and Senate bills regarding the repeal of the student loan interest deduction and the possible taxation of tuition discounts provided to graduate-level and PhD students, the final version of the tax act doesn't include any negative actions on these points.
The tax law does POSITIVELY impact 529 plans in many important ways. Under the new law, qualified distributions from these plans up to $10,000/year, per child can now be used to fund PRIVATE elementary and secondary school expenses on a tax-free basis. This includes HOMESCHOOLING expenses!
NEW QUALIFIED BUSINESS INCOME DEDUCTION
This new deduction is available to partnerships, LLCs, S-corporations, and sole proprietors who file a schedule C. It effectively REDUCES your tax liability for your pass-through income by taxing it at roughly 80% of your regular rate. Because people are in different tax brackets, it's difficult to say anything more definitive than that. The rules are complicated and some owners of pass through entities may find less benefit, but this is the general story.
This tax deduction begins to phase-out for individuals earning more than $157,500 or for married couples earning more than $315,000 if they work in certain "specified service" businesses. Under the law, a "specified service" business is a professional field like health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services (yes, that's me), or any other trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. By the way, note that this limitation specifically excludes engineers and architects. If you're an engineer or architect, say "thank you" to your lobbyists. They have served you well.
For businesses that have to make big capital investments, but then are forced to depreciate the cost of those purchases over many years, this new tax legislation is heaven sent. Under the new law, businesses can immediately expense the cost of short-lived equipment. Mining companies, hotels, food service businesses should benefit from this greatly.
Under the new rules, non-qualified deferred compensation is recognized for taxation when there is "no substantial risk of forfeiture." This basically means that as soon as the values are vested, taxes are due...even if the compensation isn't actually paid. This logic also applies to stock options and SARs. As a result, if you have these plans in place, look at them closely and be willing to make changes.
Currently, the law allows one to deduct moving expenses (within limits). Additionally, businesses could pay for those expenses on behalf of an employee and have the moving expenses not count as taxable income to the employee. Effective in 2018 under the new law, not only will moving expenses no longer be deductible to you personally, but reimbursed moving expenses by an employer will be taxable income to the employee.
Well, that's the story. As I have a chance to study the law more closely and consider the financial planning opportunities that present themselves, I'll let you know. Until then, stay well.
Bruce Wing is the president of Strategic Wealth, LLC, a Registered Investment Adviser located on the north-side of Atlanta. He can be reached at email@example.com or (678) 456-5060.
Entrepreneur, financial guy, husband and father of two great kids.