Category: Tax Services

Posted on Feb 27, 2018

The ability to deduct state and local taxes (SALT) has historically been a valuable tax break for taxpayers who itemize deductions on their federal income tax returns. Unfortunately, the Tax Cuts and Jobs Act (TCJA) limits SALT deductions for 2018 through 2025. Here’s important information that homeowners should know about the new limitation.

Old Law, New Law

Under prior law, in addition to being allowed to deduct 100% of state and local income (or sales) taxes, homeowners could deduct 100% of their state and local personal property taxes.

In other words, there was previously no limit on the amount of personal (nonbusiness) SALT deductions you could take, if you itemized. You also had the option of deducting personal state and local general sales taxes, instead of state and local income taxes (if you owed little or nothing for state and local income taxes).

Under the TCJA, for 2018 through 2025, itemized deductions for personal SALT amounts are limited to a combined total of only $10,000 ($5,000 if you use married filing separately status). The limitation applies to state and local 1) income (or sales) taxes, and 2) property taxes.

Moreover, personal foreign real property taxes can no longer be deducted at all. So, if  you’re lucky enough to own a vacation villa in Italy, a cottage in Canada or a beach condo in Cancun, you’re out of luck when it comes to deducting the property taxes.

Thinking about Selling Your Home?

There’s good news if you’re planning to sell a personal residence: The Tax Cuts and Jobs Act retains the home sale gain exclusion.

If you meet certain conditions, this valuable tax break allows you to exclude from federal income tax up to $250,000 of gain from a qualified home sale (or $500,000 if you’re a married joint-filer). The home sale gain exclusion rules remain unchanged under the final version of the new tax law — even though both the House and Senate proposed restrictions on this tax break during tax reform negotiations.

Who’s Hit Hardest?

These changes unfavorably affect individuals who pay high property taxes because:

  • They live in high-property-tax jurisdictions,
  • They own expensive homes (resulting in a hefty property tax bill), or
  • They own both a primary residence and one or more vacation homes (resulting in bigger property tax bills due to owning several properties).

People in these categories can now deduct a maximum $10,000 of personal state and local property taxes — even if they deduct nothing for personal state and local income taxes or general sales taxes.

Tax Planning Considerations

Is there any way to deduct more than $10,000 of property taxes? The only potential way around this limitation is if you own a home that’s used partially for business. For example, you might have a deductible office space in your home, lease your basement to a full-time tenant or rent your house on Airbnb during the winter months.

In those situations, you could deduct property taxes allocable to those business or rental uses, on top of the $10,000 itemized deduction limit for taxes allocable to your personal use. The incremental deductions would be subject to the rules that apply to deductions for those uses.

For example, home office deductions can’t exceed the income from the related business activity. And deductions for the rental use of a property that’s also used as a personal residence generally can’t exceed the rental income.

Important: If you pay both state and local 1) property taxes, and 2) income (or sales) taxes, trying to maximize your property tax deduction may reduce what you can deduct for state and local income (or sales) taxes.

For example, suppose you have $8,000 of state and local property taxes and $10,000 of state and local income taxes. You can deduct the full $8,000 of property taxes but only $2,000 of income taxes. If you want to deduct more state and local property taxes, your deduction for state and local income taxes goes down dollar-for-dollar.

AMT Warning

Years ago, Congress enacted the alternative minimum tax (AMT) rules to ensure that high-income individuals pay their fair share of taxes. When calculating the AMT, some regular tax breaks are disallowed to prevent taxpayers from taking advantage of multiple tax breaks.

If you’re liable for the AMT, SALT deductions — including itemized deductions for personal income (or sales) and property taxes — are completely disallowed under the AMT rules. This AMT disallowance rule was in effect under prior law, and it still applies under the TCJA.

More Limits on Homeowners

The new limits on property tax deductions will affect many homeowners. But that’s just the tip of the iceberg. If you have a large mortgage or home equity debt, your interest expense deductions also may be limited under the new law. For more information about how the TCJA affects homeowners, contact your tax advisor.

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Posted on Feb 27, 2018

The Tax Cuts and Jobs Act (TCJA) imposes new limits on home mortgage interest deductions. Here’s how the changes could affect your tax situation.

The Basics

For the 2018 through 2025 tax years, the new law generally allows you to deduct interest on only up to $750,000 of mortgage debt incurred to buy or improve a first or second residence. This type of debt is called “home acquisition indebtedness” in tax lingo. (For married individuals who file separately, the home acquisition indebtedness limit is $375,000 for 2018 through 2025.) Under prior law, you could deduct interest on up to $1 million of home acquisition indebtedness (or $500,000 for those who use married filing separate status).

In addition, for 2018 through 2025, the TCJA generally eliminates deductions for interest paid on home equity debt. Under prior law, individuals were allowed to deduct interest on up to $100,000 of home equity indebtedness. (Married individuals who filed separately could deduct interest on up to $50,000 of home equity indebtedness.)

Under prior law, you could also treat another $100,000 of mortgage debt as home acquisition indebtedness ($50,000 for married people who file separately) if the loan proceeds were used to buy or improve a first or second residence. The additional debt could be in the form of a bigger first mortgage or a home equity loan. So, technically, the limit on home acquisition indebtedness under prior law was $1.1 million (or $550,000 for those who use married filing separate status).

What Is Home Acquisition Indebtedness?

Under the tax law, home acquisition debt is a mortgage taken out “to buy, build, or substantially improve a qualified home (your main or second home). It also must be secured by that home.”

An improvement is “substantial” if it:

  • Adds to the value of your home
  • Prolongs your home’s useful life, or
  • Adapts your home to new uses.

Repairs that maintain your home in good condition, such as repainting your home, aren’t substantial improvements. However, if you paint your home as part of a renovation that substantially improves your qualified home, you can include the painting costs in the cost of the improvements.

Exceptions for Grandfathered Debts

The TCJA “grandfathers” in existing home mortgage debt under the old rules. That is, the new law doesn’t affect home acquisition indebtedness of up to $1 million (or $500,000 for married-separate filers) that was taken out 1) before December 16, 2017, or 2) under a binding contract that was in effect before December 16, 2017, so long as the home purchase closes before April 1, 2018.

Under another grandfather provision, the previous home acquisition indebtedness limits of $1 million (or $500,000 for married-separate filers) continue to apply to home acquisition indebtedness that was taken out before December 16, 2017, and then refinanced during the period extending from December 16, 2017, through 2025. But the grandfather provision applies only to the extent that the initial principal balance of the new loan doesn’t exceed the principal balance of the old loan at the time of the refinancing.

Real-World Examples

Are you confused yet? Here are some examples of how the new mortgage interest deduction limits work.

The Andersons. This married joint-filing couple has a $1.5 million mortgage that was taken out to buy their principal residence in 2016. In 2017, the Andersons paid $60,000 of mortgage interest, and they could deduct $44,000 [($1.1 million ÷ $1.5 million) x $60,000].

For 2018 through 2025, they can treat no more than $1 million as acquisition indebtedness. (Their mortgage is exempt from the new limit, because it’s grandfathered in and the old limit applies.) So, if they pay $55,000 of mortgage interest in 2018, they can deduct only $36,667 [($1 million ÷ $1.5 million) x $55,000].

Now, let’s assume that the Andersons decide to refinance their mortgage on July 1, 2018, when the existing loan’s outstanding balance is $1.35 million.

Under the grandfather provision, the couple can continue to deduct the interest on up to $1 million of the new mortgage for 2018 through 2025.

Bob. This unmarried individual has an $800,000 first mortgage that he took out to buy his principal residence in 2012. In 2016, he opened up a home equity line of credit (HELOC) and borrowed $80,000 to pay off his car loan, credit card balances and various other personal debts.

On his 2017 return, which he will file in 2018, Bob can deduct all the interest on the first mortgage under the rules for home acquisition indebtedness. For regular tax purposes, he can also deduct all the HELOC interest under the rules for home equity debt. (However, the interest deduction is disallowed under the alternative minimum tax (AMT) rules, because the HELOC proceeds weren’t used to buy or improve a first or second residence. Contact your tax advisor for more information on the AMT rules.)

On his 2018 through 2025 tax returns, Bob can continue to deduct all the interest on the first mortgage under the grandfather provision, because the loan balance is below the $1 million limit on home acquisition indebtedness. But he can’t treat any of the HELOC interest as deductible home mortgage interest. The HELOC is characterized as home equity debt and interest on home equity debt is nondeductible under the new law.

Connie. She’s an unmarried taxpayer in the same situation as Bob, except her $80,000 HELOC was used entirely to remodel her principal residence. So, her home acquisition indebtedness included her first mortgage of $800,000 plus $80,000 of home equity debt used to remodel the home.

On her 2017 return, Connie can deduct the interest on the first mortgage and the HELOC because she can treat the combined balance of the loans as home acquisition indebtedness that doesn’t exceed $1.1 million.

For 2018 through 2025, Connie can continue to deduct the interest on both loans under the grandfather rule for up to $1 million of home acquisition indebtedness.

Diana. She’s an unmarried individual with an $800,000 first mortgage that was taken out on December 1, 2017, to buy her principal residence. In 2018, she opens up a HELOC and borrows $80,000 to remodel her kitchen and bathrooms.

For 2018 through 2025, Diana can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. However, because the $80,000 HELOC was taken out in 2018, the $750,000 limit on home acquisition indebtedness under the new law precludes any deductions for the HELOC interest.

The entire $750,000 limit on home acquisition indebtedness was absorbed (and then some) by the grandfathered $800,000 first mortgage. So, the HELOC balance can’t be treated as home acquisition debt, even though the proceeds were used to improve Diana’s principal residence. Instead, the HELOC balance must be treated as home equity debt and interest on home equity debt is disallowed for the 2018 through 2025 tax years under the new law.

Eddie. He’s an unmarried taxpayer with a $650,000 first mortgage that was taken out on December 1, 2017, to buy his principal residence. In 2018, he opens up a HELOC and borrows $80,000 to remodel his basement.

For 2018 through 2025, he can deduct all the interest on the first mortgage under the grandfather provision for up to $1 million of home acquisition indebtedness. In addition, the $80,000 HELOC balance can be treated as home acquisition indebtedness, because the combined balance of the first mortgage and the HELOC is only $730,000, which is under the new limit of $750,000 for home acquisition indebtedness. So, Eddie can deduct all the interest on both loans under the rules for home acquisition indebtedness.

Important: If Eddie had used the HELOC to purchase a new car or pay off his credit card debt, it would not qualify as home acquisition indebtedness. To be eligible for this deduction, the HELOC proceeds must be used to substantially improve the taxpayer’s qualified residence. (See “What Is Home Acquisition Indebtedness?” at right.)

Got Questions?

The new limits on deducting home mortgage interest won’t affect all taxpayers. But homeowners with larger mortgages and home equity loans must take heed. Also, please understand that what you see here is based purely on our analysis of the applicable provisions in the Internal Revenue Code. Subsequent IRS guidance could differ. If you have questions or want more information about how the new home mortgage interest deduction rules affects homeowners, contact your Cornwell Jackson tax advisor.

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Posted on Feb 26, 2018

Federal income tax rates for C corporations have been reduced to a flat 21%, starting in 2018 under the Tax Cuts and Jobs Act (TCJA). But what about pass-through businesses?

But not every pass-through entity is eligible for the break — and it isn’t always 20%. Here’s an overview of how much this deduction can amount to and which types of income count as qualified business income (QBI) under the new tax law.Congress devised a special tax break for pass-through businesses to help achieve parity between the reduced corporate income tax rate and the tax rates for business income that pass through to owners of sole proprietorships, partnerships, S corporations and limited liability companies (LLCs), which are treated as sole proprietorships or partnerships for tax purposes.

Calculating the QBI Deduction: It’s All Relative

To illustrate how the qualified business income (QBI) deduction works, let’s suppose you and your spouse file a joint tax return for 2018, reporting taxable income of $300,000 (before considering any QBI deduction or any long-term capital gains (LTCGs) or qualified dividends). Your spouse has $150,000 of net income from a qualified pass-through business that isn’t a specified service business.

Your preliminary QBI deduction is $30,000 (20% x $150,000). Since your joint taxable  income is below the $315,000 threshold for the phase-in of the W-2 wage limitation, you’re unaffected by the limitation. So, your QBI deduction is the full $30,000.

Alternatively, let’s suppose your brother and his wife file a joint tax return for 2018, reporting taxable income of $355,000 (before considering any QBI deduction or any LTCGs or qualified dividends). Your brother is an architect with $150,000 of net income from a qualified pass-through business.

His preliminary QBI deduction is $30,000 (20% x $150,000). Your brother’s share of W-2 wages paid by the business is $40,000. So, his W-2 wage limitation is $20,000 (50% x $40,000). The $10,000 difference between the $30,000 preliminary QBI deduction and the $20,000 W-2 wage limitation is 40% phased in [($355,000 – $315,000) ÷ $100,000]. Therefore, your brother’s QBI deduction is limited to $26,000 [$30,000 – (40% x $10,000)].

Now let’s turn to your sister, who works as an investment broker. She files as a single taxpayer for 2018, reporting taxable income of $187,500 (before considering any QBI deduction or any LTCGs or qualified dividends). Her income includes $125,000 of net income from selling investments, a specified service business.

Her tentative QBI deduction is $25,000 (20% x $125,000). For simplicity, let’s assume she’s unaffected by the W-2 wage limitation. However, under the service business limitation, she can take into account only 40% of her service business income, or $50,000 (40% x $125,000). That’s because the service business limitation is 60% phased in at your sister’s taxable income level [($187,500 – $157,500) ÷ $50,000 = 60%]. Therefore, her QBI deduction is limited to $10,000 (20% x $50,000).

Important: If your sister’s taxable income (before considering any QBI deduction or any LTCGs or qualified dividends) was below the $157,500 threshold for the phase-in of the service business limitation, she would qualify for the full QBI deduction of $25,000.

How Much Is the Deduction?

Under prior law, net taxable income from pass-through business entities was simply passed through to owners and taxed at the owners’ level at the standard rates.

For tax years beginning after December 31, 2017, the TCJA establishes a new deduction based on a non-corporate owner’s QBI. This break is available to individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels and another restriction based on taxable income.

A non-corporate owner’s deduction generally equals:

  1. 20% of QBI from a partnership (including an LLC treated as a partnership for tax purposes), S corporation, or sole proprietorship (including a single-member LLC that is treated as a sole proprietorship for tax purposes), plus,
  2. 20% of aggregate qualified dividends from REITs, cooperatives and qualified publicly traded partnerships (special rules apply to specified agricultural and horticultural cooperatives).

The QBI deduction isn’t subtracted in calculating the non-corporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction. However, you don’t need to itemize to claim the QBI deduction.

Which Types of Income Count as QBI?

QBI is defined as the non-corporate owner’s share of items of taxable income, gain, deductions and loss from a qualified business. It includes interest income that’s properly allocable to a business, along with the aforementioned qualified dividends from REITs, cooperatives and publicly traded partnerships.

Investment-related items — such as capital gains and losses, dividends and interest income — don’t count as QBI. In addition, employee compensation and guaranteed payments from a partnership to a partner (including an LLC member who’s treated as a partner for tax purposes) don’t count as QBI.

Qualified items of income, gain, deductions and loss must be effectively connected with the conduct of a business within the United States or Puerto Rico.

Finally, QBI is calculated without considering any adjustments under the alternative minimum tax (AMT) rules.

Important: The QBI deduction and the applicable limitations are determined at the owner level. Each owner takes into account his or her share of qualified items of income, gain, deductions and loss from the pass-through entity and his or her share of W-2 wages paid by the entity.

Are There Any Restrictions?

In addition to being limited to 20% of your taxable income — calculated before the QBI deduction and before any net long-term capital gains (LTCGs) and qualified dividends that are eligible for preferential federal income tax rates — the QBI deduction is subject to two other limitations.

1. W-2 wage limitation. The QBI deduction generally can’t exceed the greater of the non-corporate owner’s share of:

  • 50% of amount of W-2 wages paid to employees by the qualified business during the tax year, or
  • The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.

Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.

Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.

2. Service business limitation. Income from specified service businesses generally doesn’t count as QBI if the owner’s taxable income (not counting any potential QBI deduction) exceeds the applicable level. This limitation potentially affects income from such professions as:

  • Health care,
  • Law,
  • Accounting,
  • Actuarial science,
  • Performance art,
  • Consulting,
  • Athletics,
  • Financial and brokerage service,
  • Investing and investment management,
  • Trading or dealing in securities, partnership interests or commodities, and
  • Any business where the principal asset of the business is the reputation or skill of one or more of its employees.

Engineering and architectural service business are specifically excluded from this limitation.

The service business limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the service business limitation is phased in over a $50,000 taxable income range or over a $100,000 taxable income range for married joint-filers.

Need Help?

Calculating the QBI deduction can be complicated. This article explains the basics, but additional factors may come into play, such as how business losses affect the QBI deduction calculation and how the deduction is calculated if you have income from several pass-through entities.

While the QBI deduction is beneficial, in some circumstances, it could make more sense to operate your business as a C corporation, which would be taxed at the flat 21% corporate income tax rate. Your tax advisor can help you sort through the complexities and find the best tax-smart strategies for your specific personal and business circumstances.

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Posted on Feb 23, 2018

The alternative minimum tax (AMT) was enacted back in 1969 to ensure that high-income individuals don’t take advantage of multiple tax breaks and avoid paying federal tax. However, in recent years, the AMT has been imposed on many middle-income taxpayers. Unfortunately, the Tax Cuts and Jobs Act (TCJA) retains the individual AMT. But AMT exemptions and phaseout thresholds have been increased for 2018 through 2025.

How it works: The AMT calculation runs side-by-side with your regular income tax calculation. The starting point for the AMT is your taxable income calculated under the regular tax rules. Next, you add in “tax preference items” and make other adjustments that disallow some regular tax breaks or change the timing of when they’re taken into account. Then you subtract an AMT exemption amount that’s based on your tax return filing status. The result is your AMT income.

Finally, you apply the AMT tax rates of 26% and 28% to your AMT income and compare the result to your regular tax liability. In effect, you’re required to pay the higher of the two amounts.

Many people are unsure how the changes in the TCJA will affect their specific tax situations. Here are some examples to help you better understand the effects of how the AMT works under the new law. (For simplicity, we’ve assumed all of these imaginary taxpayers are empty nesters who don’t qualify for education-related tax credits or child tax credits.)

The Adams

It’s scary to think that taxpayers with less than $100,000 of taxable income could be hit with the AMT, but that’s just what happened to the Adams family in 2017. Fortunately, the TCJA brings good news: The Adams won’t owe AMT (assuming the same facts) for 2018 under the new law. Here’s why.

In 2017, this married joint-filing couple exercised an “in-the-money” incentive stock option (ISO) granted by the husband’s employer. The difference between the exercise price of the ISO shares and the trading price on the exercise date (the bargain element) was $50,000. The bargain element doesn’t count as income under the regular tax rules, but it does count as income under the AMT rules.

The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular Tax Calculation

Salary

$75,000
Other ordinary income

$2,000
Adjusted gross income

$77,000
Standard deduction

($12,700)
Personal exemptions

($8,100)
Taxable income

$56,200
Regular tax liability

$7,498

2017 AMT calculation

Regular taxable income

$56,200
ISO bargain element

$50,000
Standard deduction

$12,700
Personal exemptions

$8,100
AMT income before exemption

$127,000
AMT exemption (no phase-out)

($84,500)
AMT taxable income

$42,500
AMT liability

$11,050

So, for 2017, the Adams family owes $11,050 for the AMT.

Important note: This calculation would have been more complicated if the couple itemized deductions. But, for simplicity, we’ve assumed that they took the standard deduction instead.

Now, let’s assume the same facts for 2018. The calculation of the couple’s 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$75,000
Other ordinary income

$2,000
Adjusted gross income

$77,000
Standard deduction

($24,000)
Taxable income

$53,000
Regular tax liability

$5,979

2018 AMT calculation

Regular taxable income

$53,000
ISO bargain element

$50,000
Standard deduction

$24,000
AMT income before exemption

$127,000
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$17,600
AMT liability

$4,576

Thanks to the TCJA, the Adams will not owe AMT in 2018. They’ll owe the regular tax amount of $5,979. So, the new law benefits this couple.

The Bradys

Like the Adams, the Bradys experience a bunch of good luck under the TCJA. That is, they’ll owe AMT under the old rules but not new rules. Here’s how their tax situation will improve from 2017 to 2018.

In 2017, this married joint-filing couple had itemized deductions totaling $50,000, including $25,000 for state and local taxes. The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular tax calculation

Salary

$310,000
Other ordinary income

$2,000
Adjusted gross income

$312,000
Itemized deductions

($50,000)
Personal exemptions

($8,100)
Taxable income

$253,900
Regular tax liability

$59,004

AMT calculation

Regular taxable income

$253,900
Itemized deduction for state and local taxes

$25,000
Personal exemptions

$8,100
AMT income before exemption

$287,000
AMT exemption (after partial phase-out)

($52,975)
AMT taxable income

$234,025
AMT liability

$61,771

For 2017, the Bradys owe the AMT amount of $61,771.

Now assume the same facts for 2018. The calculation of the couple’s 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$310,000
Other ordinary income

$2,000
Adjusted gross income

$312,000
Itemized deductions*

($35,000)
Taxable income

$277,000
Regular tax liability

$55,059

*For 2018 through 2025, itemized deductions for state and local income and property taxes are limited to $10,000 (combined).

2018 AMT calculation

Regular taxable income

$277,000
Itemized deduction for state and local taxes

$10,000
AMT income before exemption

$287,000
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$177,600
AMT liability

$46,176

Thanks to the TCJA, the Bradys won’t be hit with the AMT for 2018. They’ll just owe the regular tax amount of $55,059. So the new tax law benefits this couple.

The Cunninghams

Tax Day is never a happy day in the Cunningham house. This is the wealthiest hypothetical couple in our examples. So, it’s not surprising that they’ll owe AMT under both the old and new rules.

In 2017, this married joint-filing couple exercised an in-the-money ISO granted by the wife’s employer. The difference between the exercise price of the ISO shares and the trading price on the exercise date (the bargain element) was $50,000. The calculation of the couple’s 2017 regular tax and AMT liabilities are as follows:

2017 Regular tax calculation

Salary

$400,000
Other ordinary income

$12,550
Adjusted gross income

$412,550
Standard deduction

($12,700)
Personal exemptions

($8,100)
Personal exemption phaseout

$6,480
Taxable income

$398,230
Regular tax liability

$106,633

2017 AMT calculation

Regular taxable income

$398,230
ISO bargain element

$50,000
Standard deduction

$12,700
Partially phased-out personal exemptions*

$1,620
AMT income before exemption

$462,550
AMT exemption (after partial phase-out)

($9,088)
AMT taxable income

$453,462
AMT liability

$123,213

* The personal exemption less the phaseout ($8,100 – $6,480).

So, the Cunninghams owe $123,213 in AMT for 2017.

Assuming the same facts for 2018, the calculation of 2018 regular tax and AMT amounts under the TCJA are as follows:

2018 Regular tax calculation

Salary

$400,000
Other ordinary income

$12,550
Adjusted gross income

$412,550
Standard deduction

($24,000)
Taxable income

$388,550
Regular tax liability

$87,715

2018 AMT calculation

Regular taxable income

$388,550
ISO bargain element

$50,000
Standard deduction

$24,000
AMT income before exemption

$462,550
AMT exemption (no phase-out)

($109,400)
AMT taxable income

$353,150
AMT liability

$95,052

In 2018, this couple is still in the AMT zone and owes $95,052 under the AMT rules. However, there is something for the Cunninghams to be happy about: Their 2018 AMT bill is much lower than their 2017 AMT bill, because the increased AMT exemption for 2018 is fully deductible. Therefore, the new law greatly benefits them, even though they still owe the AMT.

Applying Fiction in the Real World

These fictitious examples showcase how the AMT rules have changed for 2018 through 2025 under the TCJA. Although fewer taxpayers will be hit by this dreaded tax under the new law, it still will create headaches for some taxpayers. Consult your tax advisor to discuss customized strategies for minimizing the AMT.

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Posted on Feb 14, 2018

The new Tax Cuts and Jobs Act (TCJA) significantly changes some parts of the tax code that relate to personal tax returns. In addition to lowering most of the tax rates and increasing the standard deduction, the TCJA repeals, suspends or modifies some valuable tax deductions. As a result, millions of Americans who have itemized deductions in the past are expected to claim the standard deduction for 2018 through 2025.

New Law Retains Several Tax Deductions

The Tax Cuts and Jobs Act (TCJA) doesn’t suspend or eliminate every tax deduction on the books. Certain deductions survived the chopping block in their current form, or with modifications, including:

  • Medical and dental expenses,
  • Charitable contributions,
  • Gambling losses,
  • IRA contributions,
  • Educator expenses,
  • Self-employed health insurance,
  • Self-employed retirement plan contributions, and
  • Student loan interest.

Important: The medical expense deduction has been temporarily enhanced under the TCJA. Previously, the threshold for deducting expenses was 10% of adjusted gross income (AGI). But it’s lowered to 7.5% of AGI for 2017 and 2018.
The TCJA provisions for individuals generally take effect for the 2018 tax year and “sunset” after 2025. That means that they technically expire in eight years unless Congress takes further action. In the meantime, you still have a shot at several key tax deductions on your 2017 return before they’re scheduled to expire. This is the return you must file or extend by April 17, 2018.

Here are six popular federal income tax breaks that will be suspended or modified by the new law. Generally, prior law continues to apply to these deductions for your 2017 tax year, so you can write off the expenses with little or no limitation for 2017.

1. State and Local Taxes (SALT)

The SALT deduction was a hot-button issue in tax reform talks. Eventually, Congress made a concession to residents of high-tax states, but it may be a hollow victory for some people.

Under prior law, if you itemized deductions you could generally deduct the full amount of your 1) state and local property taxes, and 2) your state and local income taxes or state and local general sales taxes. Now the TCJA limits the deduction to $10,000 annually for any combination of these taxes, beginning in 2018. But the deduction does you no good if you don’t itemize.

On your 2017 return, you can still opt to deduct the full amount of 1) property taxes, and 2) state and local income taxes or sales taxes. The income tax deduction is usually preferable to the sales tax deduction to those who reside in states with high income tax rates. Conversely, you can elect to deduct general state and local sales tax if your state and local income tax bill is small or nonexistent. If you opt for the sales tax deduction, you can deduct your actual expenses or a flat amount based on an IRS table, plus additional actual sales tax amounts for certain big-ticket items (such as cars and boats).

2. Mortgage Interest

Home mortgage interest can still be deducted after 2017, but new limitations will result in smaller deductions for some taxpayers.

For 2017 returns, you can deduct mortgage interest paid on the first $1 million of acquisition debt (typically, a loan to buy a home) and interest on the first $100,000 of home equity debt for a qualified residence. It doesn’t matter how the proceeds for a home equity loan are used.

Under the new law, the threshold for acquisition debt is generally reduced to $750,000 for loans made after December 15, 2017. In addition, the deduction for home equity debt is repealed. However, interest on home equity debt that is used to make home improvements might still be deductible if it can be characterized as acquisition debt. We’ll have to wait for IRS guidance on this issue to know for sure. In addition, if home equity debt is used to fund a pass-through business that the taxpayer owns (such as a partnership or S corporation or sole proprietorship), the interest expense may qualify as a deductible business expense (subject to new restrictions on business interest expense deductions under the TCJA).

Homeowners with existing mortgages are “grandfathered” under the new rules, even if the loan is refinanced (up to the existing debt amount). But you can’t deduct any interest on home equity debt that’s used for personal expenditures (such as a new car, a vacation or your child’s college costs) after 2017.

3. Casualty and Theft Losses

For 2018 through 2025, the TCJA suspends the deduction for casualty and theft losses except for damage suffered in certain federal disaster areas. Under prior law — which applies to your 2017 tax return — unreimbursed casualty losses are deductible in excess of 10% of your adjusted gross income (AGI), after subtracting $100 for each casualty or theft event.

For example, suppose you have an AGI of $100,000 in 2017 and incur a single casualty loss of $21,100. You can deduct $11,000 [$21,100 – $100 – (10% of $100,000)]. In addition, this loss must be caused by an event that is “sudden, unexpected or unusual.”

The new law suspends this deduction except for losses incurred in an area designated by the President as a federal disaster area under the Stafford Act. Special rules may come into play if a taxpayer realizes a gain on an involuntary conversion.

4. Miscellaneous Expenses

Under prior law, deductions for most miscellaneous expenses were subject to an annual floor based on 2% of AGI. From 2018 through 2025, this deduction won’t be available at all.

For your 2017 return, you can still deduct miscellaneous expenses for the year above 2% of your AGI. These expenses typically relate to production of income, including:

  • Tax advisory and return preparation fees,
  • Investment fees,
  • Hobby losses, and
  • Unreimbursed employee business expenses.

For example, suppose you have AGI of $100,000 in 2017 and incur $5,000 of qualified unreimbursed employee business expenses. You can deduct any expenses over 2% of your AGI ($2,000). So, you can claim $3,000 ($5,000 – $2,000) of unreimbursed business expenses on Schedule A, absent any other limits.

Important note: Under the new law, taxpayers also can’t deduct miscellaneous expenses, including investment fees, for purposes of calculating net investment income. As a result, some taxpayers may pay more net investment income tax (NIIT), starting in 2018.

5. Job-Related Moving Expenses

Under prior law, you could claim qualified job-related moving expenses as an “above-the-line” deduction. Under the new law, this deduction is suspended for 2018 through 2025, except for expenses incurred by active duty military personnel.

To qualify for a deduction for moving expenses on your 2017 return, you must meet a two-part test involving distance and time:

Distance. Your new job location must be at least 50 miles farther from your old home than your old job location was from your former home.

Time. If you’re an employee, you must work full-time for at least 39 weeks during the first 12 months after you arrive in the general area of the new job. The time requirement is doubled for self-employed taxpayers.

Assuming you pass the test, you can deduct the reasonable costs of moving your household goods and personal effects to a new home in 2017, as well as the travel expenses (including lodging, but not meals) between the two locations. In lieu of actual vehicle expenses, you may use a flat rate of $0.17 per mile for 2017.

6. Alimony

Currently, alimony paid under a divorce or separation agreement is deductible by the spouse who pays it and taxable to the spouse who receives it. The TCJA repeals the alimony deduction and the corresponding rule requiring inclusion in income for the recipient.

In addition, unlike most of the other tax law changes for individuals, this provision doesn’t go into effect right away. It’s effective for agreements entered into after December 31, 2018. In other words, taxpayers with agreements executed before that cutoff date are allowed to follow the old rules. But payers under post-2018 agreements get no deduction. This change is permanent for post-2018 agreements; it doesn’t sunset after 2025.

More Information

This list isn’t complete. But it’s a good starting point for preparing your 2017 income tax return. If you have questions or concerns, contact your tax advisor.

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Posted on Feb 9, 2018

On January 22, President Trump signed into law a short-term government funding bill. It ended the brief government shutdown by funding the federal government through February 8. It also suspends the following Affordable Care Act (ACA) taxes, which were designed to help fund health care coverage provided under the ACA.

1. Cadillac Tax

Under prior law, for tax years beginning after December 31, 2019, a 40% excise tax was scheduled to apply to any “excess benefit” provided to any employee who’s covered under any “applicable employer-sponsored coverage.” This tax is commonly known as the “Cadillac tax,” because it affects upper-end employer-sponsored insurance coverage. It’s paid by the coverage provider, which is typically the health insurance provider or the entity that administers the plan benefits.

The Cadillac tax was originally scheduled to apply for tax years beginning after 2017 but it has been delayed a number of times, most recently by the 2016 Consolidated Appropriations Act.

The recent government funding law further delays the Cadillac tax for an additional two years. It’s now scheduled to apply for tax years beginning after December 31, 2021.

2. Medical Device Tax

Under prior law, for tax years beginning after December 31, 2017, a 2.3%-of-sales-price excise tax was to be imposed on the sale of any taxable medical device by the device’s manufacturer, producer or importer.

Originally, the medical device tax was scheduled to apply for sales after December 31, 2012. But it has been suspended, most recently by the 2015 Protecting Americans from Tax Hikes (PATH) Act.

The January 2018 government funding law further delays the medical device tax for an additional two years. It’s now scheduled to apply to sales after December 31, 2019. The delay is retroactive to the beginning of 2018.

3. Annual Fee on Health Insurance Providers

Effective for calendar years beginning after December 31, 2013, U.S. health insurance providers generally were supposed to face an annual flat fee. The fee is a fixed amount allocated among all providers based on their relative market share as determined by each entity’s net premiums written for the data year (the year immediately preceding the year in which the fee is paid).

The annual fee on health insurance providers was suspended for 2017 by the 2016 Consolidated Appropriations Act. Now it’s been further suspended by the recent government funding law. The annual fee on health insurance providers is now scheduled to apply in tax years beginning after December 31, 2019.

What’s the Status of Other ACA Provisions?

The ACA individual mandate was permanently eliminated under the Tax Cuts and Jobs Act (but the change isn’t effective yet). This mandate requires taxpayers without coverage by a qualifying health plan to pay a penalty. The elimination of the individual mandate is effective for months beginning after December 31, 2018. So, the individual mandate is in effect for 2017 and 2018.

In addition, the employer mandate for providing health coverage has been retained. This “shared responsibility” mandate imposes a penalty on a “large employer” if it doesn’t offer “minimum essential” health insurance coverage or if one or more of its full-time employees obtains a premium tax credit to help purchase health coverage. The employer mandate applies to for-profit companies, not-for-profit organizations and government entities.

Thanks to the new government funding law, no new ACA-related taxes or penalties are scheduled to go into effect in 2018. For more information on the status of the remaining ACA provisions, contact your employee benefits or tax advisor.

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Posted on Feb 8, 2018

Unfortunately, the Tax Cuts and Jobs Act (TCJA) retains the individual Alternative Minimum Tax (AMT). But there’s a silver lining: The AMT rules now reduce the odds that you’ll owe the AMT for 2018 through 2025. Plus, even if you’re still in the AMT zone, you’ll probably owe less AMT than you did under the old rules.

Here’s what you need to know about the new-and-improved AMT rules for 2018 through 2025.

Important note: The prior law version of the AMT still applies for your 2017 income tax return, which is due on April 17, 2018.

Why the AMT Hits Upper-Middle-Income Taxpayers

Under prior law, many high-income taxpayers weren’t affected by the AMT. That’s because, after numerous legislative changes, many of their tax breaks were already cut back or eliminated under the regular income tax rules. So, there was no need to address the AMT. For instance, the passive activity loss rules restrict the tax benefits that can be reaped from “shelter” investments like rental real estate and limited partnerships.

If your income exceeds certain levels, you run into phaseout rules that chip away or eliminate other tax breaks. As a result, higher-income taxpayers had little or nothing left to lose by the time they got to the AMT calculation, while many upper-middle-income folks still had plenty left to lose. Also, the highest earners were in the 39.6% regular federal income tax bracket under prior law, which made it less likely that the AMT — with its maximum 28% rate — would hit them.

In addition, the AMT exemption is phased out as income goes up. This amount is deducted in calculating AMT income. Under prior law, this exemption had little or no impact on individuals in the top bracket, because the exemption was completely phased out. But the exemption phaseout rule made upper-middle-income taxpayers even much more likely to owe AMT under prior law.

Under the TCJA, upper-middle-income people are somewhat less likely to owe the AMT, and if they do, their AMT liabilities are likely to be lower.

The Basics

Think of the AMT as a separate tax system that’s similar to the regular federal income tax system. The difference is that the AMT system taxes certain types of income that are tax-free under the regular tax system and disallows some regular tax deductions and credits.

The maximum AMT rate is 28%. By comparison, the maximum regular tax rate for individuals was 39.6% for 2017 under prior law. The maximum regular tax rate for individuals is reduced to 37% for 2018 through 2025 thanks to the TCJA.

For 2017, the maximum 28% AMT rate kicks in when AMT income exceeds $187,800 for married joint-filing couples and $93,900 for others. For 2018, the maximum 28% AMT rate starts when AMT income exceeds $191,500 for married joint-filing couples and $95,750 for others.

Inflation-Adjusted Exemption

Under the AMT rules, you’re allowed a relatively large inflation-adjusted AMT exemption. This amount is deducted when calculating your AMT income. The TCJA significantly increases the exemption for 2018 through 2025. The exemption is phased out when your AMT income surpasses the applicable threshold, but the TCJA greatly increases those thresholds for 2018 through 2025.

If your AMT bill for the year exceeds your regular tax bill, you must pay the  higher AMT amount. Originally, the AMT was enacted to ensure that very wealthy people didn’t avoid paying tax by taking advantage of “too many” tax breaks. Unfortunately, the AMT also hits some unintended targets. (See “Why the AMT Hits Upper-Middle-Income Taxpayers” at right.) The new AMT rules are better aligned with Congress’s original intent.

Key Figures

The following table summarizes the AMT exemptions and phaseout thresholds for 2017:

  Unmarried individuals Married couples who file jointly Married individuals who file separately
AMT exemption amount

$54,300

$84,500

$42,250
Phaseout starts at

$120,700

$160,900

$80,450
Completely phased out at

$337,900

$498,900

$249,450

The following table summarizes the AMT exemptions and phaseout thresholds for 2018:

  Unmarried individuals Married couples who file jointly Married individuals who file separately
AMT exemption amount

$70,300

$109,400

$54,700
Phaseout starts at

$500,000

$1 million

$500,000
Completely phased out at

$781,200

$1,437,600

$718,800

Under both old and new law, the exemption is reduced by 25% of the excess of AMT income over the applicable exemption amount. But under the TCJA, only those with really high incomes will see their exemptions phased out, while others (including middle-income taxpayers) will benefit from full exemptions.

Risk Factors Before and After the TCJA

So, who will be hit by the AMT? Various interacting factors come into play when evaluating whether the AMT will apply or not, but there are several common warning signs to watch for under the old and new rules.

Substantial income. High income can cause the AMT exemption to be partially or completely phased out. The TCJA significantly increases the exemptions and thresholds for 2018 through 2025, reducing or eliminating the AMT hit for most taxpayers.

Large itemized deductions for state and local income and property taxes. Under the prior law, these taxes can be fully deducted for regular federal income tax purposes, but they’re completely disallowed under the AMT rules. Under the TCJA, the regular tax deduction for state and local income and property taxes is limited to $10,000. So, this risk factor has lost most of its teeth.

Multiple personal and dependent exemption deductions. Under the prior law, these deductions are disallowed under the AMT rules. Under the new law, personal and dependent exemption deductions are eliminated. So, this risk factor is gone under the TCJA.

Exercise of “in-the-money” incentive stock options (ISOs). The so-called bargain element (the difference between the market value of the shares on the exercise date and the exercise price) doesn’t count as income under the regular tax rules, but it does count as income under the AMT rules. Unfortunately, this risk factor still exists under the new law.

Significant miscellaneous itemized deductions. Examples of these deductions include investment expenses, fees for tax advice and unreimbursed employee business expenses. Under the prior law, you can write off these deductions for regular tax purposes, but they are disallowed under the AMT rules. Under the TCJA, most miscellaneous itemized deductions are eliminated. So, this risk factor is basically gone.

Interest from “private activity bonds.” This income is tax-free for regular federal tax purposes, but it’s taxable under the AMT rules. Unfortunately, this risk factor still exists under the new law.

Significant depreciation write-offs. Individuals may deduct depreciation expense for fixed assets — such as machinery, equipment, computers, furniture and fixtures — from owning sole proprietorships or investing in S corporations, limited liability companies or partnerships. These assets must be depreciated over longer periods under the AMT rules, which increases the likelihood that you’ll owe the AMT.

Under the new law — for assets placed in service between September 28, 2017, and December 31, 2022 — businesses can deduct the entire cost of many depreciable assets in the first year under both the regular tax rules and the AMT rules. So this risk factor is diminished for newly added assets. However, it continues to exist for older assets that are subject to the depreciation schedules allowed under the prior law.

Contact a Tax Pro

Though the new law reduces the odds that you’ll owe the AMT for 2018 through 2025, don’t automatically assume you’ll be exempt. Be aware of the risk factors that still apply under the new law, because IRS auditors are specifically trained to find them. If you fail to report your AMT obligation, you’ll owe back taxes, interest, and possibly penalties.

Ask your tax advisor about your AMT exposure. If you’re at risk, some planning strategies may be available to lower your AMT profile.

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Posted on Jan 31, 2018

On January 11, the IRS released updated 2018 income tax withholding tables, which reflect   changes made by the new Tax Cuts and Jobs Act. This is the first in a series of steps that the IRS will take to help improve the accuracy of withholding following major changes made by the new tax law, the IRS stated.

The updated withholding information, shows the new rates for employers to use during 2018. Employers should begin using the 2018 withholding tables as soon as possible, but not later than February 15, 2018. They should continue to use the 2017 withholding tables until implementing the 2018 withholding tables.

To view the tables in Notice 1036, click here: https://www.irs.gov/pub/irs-pdf/n1036.pdf

Many employees will begin to see increases in their paychecks to reflect the new law in February. According to the IRS, “the time it will take for employees to see the changes in their paychecks will vary depending on how quickly the new tables are implemented by their employers and how often they are paid — generally weekly, biweekly or monthly.”

The new withholding tables are designed to work with the W-4 forms that workers have already filed with their employers to claim withholding allowances. This minimizes the burden on taxpayers and employers, the IRS stated. At this time, employees don’t have to do anything.

Why the Changes Are Needed

The new law makes a number of changes for 2018 that affect individual taxpayers. The new tables reflect:

  • An increase in the standard deduction,
  • A repeal of personal exemptions, and
  • Changes in tax rates and tax brackets.

For people with simpler tax situations, the new tables are designed to produce the correct amount of tax withholding. The revisions are also aimed at avoiding over- and under-withholding of tax as much as possible.

To help people determine their withholding, the IRS is also revising the withholding tax calculator on IRS.gov. The tax agency anticipates this calculator should be available by the end of February. Taxpayers are encouraged to use the calculator to adjust their withholding once it is released.

The IRS is also working on revising Form W-4. The revised Form W-4 and the revised calculator will reflect additional changes in the new law, such as:

  • Changes in available itemized deductions,
  • Increases in the child tax credit, the new dependent credit and repeal of dependent exemptions.

The calculator and new Form W-4 can be used by employees who wish to update their withholding in response to the new law or changes in their personal circumstances in 2018, and by workers starting a new job. Until a new Form W-4 is issued, employees and employers should continue to use the 2017 Form W-4.

In addition, the IRS announced it will help educate taxpayers about the new withholding guidelines and the calculator. The effort will be designed to help workers ensure that they aren’t having too much or too little withholding taken out of their pay so that when they file their tax returns they don’t get a surprise.

Some Expressing Concern

Two Democratic congressmen are questioning whether enough taxes will be taken out of the checks of employees under the IRS’s 2018 withholding tables. In letters sent to federal tax officials, Senator Ron Wyden (OR) and Representative Richard Neal (MA) expressed concern that the new withholding tables would “result in millions of taxpayers receiving larger after-tax paychecks this election year but ultimately owing federal income tax when they file in 2019.”

More Changes Next Year

For 2019, the IRS anticipates making further changes involving withholding. The IRS will work with the business and payroll community to encourage workers to file new Forms W-4 next year and share information on changes in the new tax law that impact withholding.

Acting IRS Commissioner David Kautter noted: “Payroll withholding can be complicated, and the needs of taxpayers vary based on their personal financial situation. In the weeks ahead, the IRS will be providing more information to help people understand and review these changes.”

If you have questions about whether you will have enough taxes taken out of your paycheck for 2018, consult with your Cornwell Jackson tax advisor.

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Posted on Jan 30, 2018

The Tax Cuts and Jobs Act (TCJA) provides businesses with more than just lower income tax rates and other provisions you may have heard about. Here’s an overview of some lesser-known, business-friendly changes under the new law, along with a few changes that could affect some businesses adversely.

Good News for New Business Tax Reforms

Many of the new law’s provisions will reduce the amount of taxes your business will owe, starting in 2018. Here are four examples that you might not be familiar with:

1. Faster Depreciation for Certain Real Property

For property placed in service after December 31, 2017, the separate definitions of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property are eliminated. Under the TCJA, those items are now lumped together under the description of qualified improvement property, which can be depreciated straight-line over 15 years.

2. Faster Depreciation for New Farming Machinery and Equipment

The TCJA shortens the depreciation period from seven years to five years for new machinery and equipment that is placed in service after December 31, 2017, and used in a farming business (other than grain bins, cotton ginning assets, fences or other land improvements). In addition, the faster double-declining balance method can be used to calculate annual depreciation deductions for these types of machinery and equipment.

3. New Credit for Employer-Paid Family and Medical Leave

For wages paid tax years beginning after December 31, 2017, and before January 1, 2020, the TCJA allows employers to claim a general business tax credit equal to 12.5% of wages paid to qualifying employees while they’re on family or medical leave. There’s a hitch: You must pay the employee at least 50% of his or her normal wage while on leave.

Additionally, the credit rate increases by 0.25% for each percentage point that the wage rate paid while on leave exceeds 50% of the normal rate. However, the maximum credit rate is 25%. For example, if you pay an employee 60% of her normal wage rate while on leave, you could qualify for a general business credit equal to 15% (12.5% + (10 x 0.25%)), if all other conditions are met.

Important: To be eligible for the credit, the employer must provide all qualifying full-time employees at least two weeks of annual paid family and medical leave. Part-time employees must be given proportional leave time.

4. Accounting Change for Long-Term Construction Contracts

Under prior law, construction companies were generally required to use the less-favorable percentage-of-completion method (PCM) to calculate annual taxable income from long-term contracts for the construction or improvement of real property. However, construction companies with average annual gross receipts of $10 million or less in the preceding three tax years were exempt from this requirement.

The TCJA expands this exemption to cover contracts for the construction or improvement of real property if they:

  • Are expected to be completed within two years, and
  • Are performed by a taxpayer with average annual gross receipts of $25 million or less for the preceding three tax years.

This beneficial change is effective for contracts entered into in 2018 and beyond.

Bad News for New Business Tax Reforms

The tax breaks provided by the TCJA will cost the federal government a significant amount of revenue. As a result, the bill needed to raise revenue through other tax law changes. Here are two examples:

1. Less Favorable Treatment of Carried Interests

Historically, private equity funds and hedge funds have been structured as limited partnerships. Under prior law, carried interest arrangements allowed private equity fund and hedge fund managers to give up their right to receive current fees for their services and, instead, receive an interest in future profits from the private equity/hedge fund partnership. These arrangements are called “carried interests” because a private equity/hedge fund manager doesn’t pay anything for the partnership profits interest. To add to the appeal, the private equity/hedge fund manager isn’t taxed on the receipt of the carried interest (because it’s not considered to be a taxable event).

The tax planning objective of carried interest arrangements is to trade current fee income for partnership profits interest. Current fee income would be treated as high-taxed ordinary income and subject to federal employment taxes. But a partnership profits interest is expected to generate future long-term capital gains that will be taxed at lower rates.

For tax years beginning after 2017, carried interest arrangements face a major hurdle: The TCJA imposes a three-year holding period requirement in order for profits from certain partnership interests received in exchange for the performance of services to be treated as low-taxed, long-term capital gains.

2. Self-Created Intangible Assets No Longer Treated as Capital Assets

Effective for dispositions in 2018 and beyond, the TCJA stipulates that certain intangible assets can no longer be treated as favorably-taxed capital gain assets. This change affects:

  • Inventions,
  • Models and designs (whether or not patented), and
  • Secret formulas.

The change will cover the above types of intangibles that are 1) created by the taxpayer, or 2) acquired from the creating taxpayer with the new owner’s basis in the intangible determined by the creating taxpayer’s basis. The latter situation could happen if the creating taxpayer gifts an intangible to another individual or contributes an intangible to another taxable entity, such as a corporation or partnership.

Need Help?

If you’re feeling overwhelmed by the new tax law, you’re not alone. The TCJA is expected to have far-reaching effects on business taxpayers. Contact your Cornwell Jackson tax advisor to review the substance of the bill and how your company can manage the impact.

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Posted on Jan 30, 2018

Congress enacted the so-called “kiddie tax” rules to prevent parents and grandparents in high tax brackets from shifting income (especially from investments) to children in lower tax brackets. Congress recently revamped this tax under the Tax Cuts and Jobs Act (TCJA).

Trust and Estate Tax Rates for 2018

Use the following tax rates to compute the kiddie tax for 2018 to 2025:

2018 Ordinary Income Tax Rates for Trusts and Estates

10% tax bracket $0 – $2,550
24% tax bracket $2,551 – $9,150
35% tax bracket $9,151 – $12,500
37% tax bracket $12,501 and above

2018 Long Term Capital Gains and Qualified Dividends Tax Rates for Trusts and Estates

0% tax bracket $0 – $2,600
15% tax bracket $2,601 – $12,700
20% tax bracket $12,701 and above

What changed? The TCJA only revises the kiddie tax rate structure. The rest of the kiddie tax rules are the same as before. Here’s what you need to know about how this tax can come into play under the new law.

Important note: For simplicity, throughout this article we use the terms  “child” and “children” to apply to both children and young adults under age 24 who may be subject to the kiddie tax.

Kiddie Tax Basics

For 2018 through 2025, the TCJA revises the kiddie tax rules to tax a portion of a child’s net unearned income at the rates paid by trusts and estates. These rates can be as high as 37% for ordinary income or, for long-term capital gains and qualified dividends, as high as 20%. (See “Trust and Estate Tax Rates for 2018,” at right.)

The trust and estate tax rate structure is unfavorable because the rate brackets are compressed compared to the brackets for single individuals. In other words, the kiddie tax rules can override the lower rates that would otherwise apply to an affected child’s unearned income.

By comparison, under prior law, the kiddie tax rules taxed a portion of an affected child’s unearned income at the parent’s marginal tax rate if that rate was higher than the child’s rate. For 2017, the parent’s rate could be as high as 39.6% for ordinary income or, for long-term capital gains and dividends, as high as 20%.

Important note: For purposes of the kiddie tax rules, the term “unearned income” refers to income other than wages, salaries, professional fees and other amounts received as compensation for personal services rendered. Examples of unearned income include capital gains, dividends and interest. Earned income from a job or self-employment isn’t subject to the kiddie tax.

In calculating the federal income tax bill for a child who’s subject to the kiddie tax, the child is allowed to deduct his or her standard deduction. For 2018, if the TCJA hadn’t passed, the standard deduction for a child for whom a dependent exemption deduction would have been allowed under prior law is the greater of:

  • $1,050, or
  • Earned income plus $350, not to exceed $12,000.

For 2018, the kiddie tax potentially affects children who don’t provide over half of their own support in 2018 and who live with their parents for more than half of the year.

The Age Factor

The kiddie tax can potentially apply until the year that a child turns age 24. More specifically, the kiddie tax applies when all four of the following requirements are met for the tax year in question:

1. The child doesn’t file a joint return for the year.

2. One or both of the child’s parents are alive at the end of the year.

3. The child’s net unearned income for the year exceeds the threshold for that year, and the child has positive taxable income after subtracting any applicable deductions, such as the standard deduction. The unearned income threshold for 2018 is $2,100. If the unearned income threshold isn’t exceeded, the kiddie tax doesn’t apply. If the threshold is exceeded, only unearned income in excess of the threshold is hit with the kiddie tax.

4. The child falls under one of the following age-related rules:

Rule 1. The child is 17 or younger at year end.

Rule 2. The child is 18 at year end and doesn’t have earned income that exceeds half of his or her support. (Support doesn’t include amounts received as scholarships.)

Rule 3. The child is age 19 to 23 at year end and 1) is a student, and 2) doesn’t have earned income that exceeds half of his or her support. A child is considered to be a student if he or she attends school full-time for at least five months during the year. (Again, support doesn’t include amounts received as scholarships.)

Kiddie Tax in the Real World

Here are several examples to help you understand who could be hit with the kiddie tax after the changes made by the TCJA:

Adam will be 17 on December 31, 2018. So, he falls under Rule 1 (above). For 2018, he will be subject to the kiddie tax if the other three requirements are also met.

Beth will be 19 on December 31, 2018. She doesn’t have any earned income for the year, and she’s a full-time student for the entire year. She falls under Rule 3. For 2018, she will be subject to the kiddie tax if the other three requirements are also met.

Claire is 19 on December 31, 2018. She’s not a student for 2018, so Claire is exempt from the kiddie tax for 2018.

Dennis will be 21 on December 31, 2018, and he graduates from college in May 2018. He qualifies as a full-time student, because he’s enrolled for the first five months of the year. Dennis couldn’t find a job after graduation, so he doesn’t provide over half of his own support for the year. Therefore, he’s subject to the kiddie tax for 2018 under Rule 3, if the other three requirements are also met.

Ellie will be 24 on December 31, 2018. Even though Ellie is still enrolled in college, she’s exempt from the kiddie tax for 2018 and all subsequent years, because none of the age-related rules apply to her.

The Mechanics

There are four steps when calculating the federal income tax bill under the kiddie tax rules.

1. Add up the child’s net earned income and net unearned income.

2. Subtract the child’s standard deduction to arrive at taxable income.

3. Compute tax for the portion of taxable income that consists of net earned income using the regular rates for a single taxpayer. (See “Computing Tax on a Child’s Earned Income,” below.)

4. The kiddie tax will be assessed on the portion of taxable income that consists of net unearned income and that exceeds the unearned income threshold. (That threshold is $2,100 for 2018.) Compute kiddie tax for this amount using the rates that apply to trusts and estates. (See “Trust and Estate Tax Rates for 2018,” above.)

To illustrate how to calculate a child’s federal tax bill, let’s look at one of the previous examples.  Adam (age 17) has $2,000 of earned income from delivering newspapers and $7,000 of unearned ordinary income. His standard deduction is $2,350 ($2,000 of earned income + $350).

Adam’s taxable income is $6,650 ($2,000 + $7,000 − $2,350). The entire $6,650 is treated as unearned income because his $2,350 standard deduction offsets all of his earned income plus the first $350 of his unearned income.

The first $2,100 (the amount up to the kiddie tax unearned income threshold) is taxed at 10% under the regular rates for single taxpayers, resulting in $210 of tax.

The remaining $4,550 of taxable income ($6,650 – $2,100) falls under the kiddie tax rules and is, therefore, taxed at the rates for trusts and estates as follows:

    • The first $2,550 is taxed at 10%, resulting in $255 of tax.
  • The remaining $2,000 ($4,550 – $2,550) is taxed at 24%, resulting in $480 of tax.

So Adam’s tax bill is $945 ($210 + $255 + $480).

Important note: Without the kiddie tax, all of Adam’s $6,650 of taxable income would have been taxed at 10% under the regular rates for single taxpayers, resulting in only $665 of tax.

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The kiddie tax is somewhat easier to calculate under the TCJA. But it can still be confusing. Depending on your circumstances, your children or grandchildren may be hit even harder by the kiddie tax under the new rules. If your child or grandchild has significant unearned income, contact your Cornwell Jackson tax advisor to identify strategies that will help reduce the kiddie tax for 2018 and beyond.

Computing Tax on a Child’s Earned Income

2018 Ordinary Income Tax Rates for Single Taxpayers

10% tax bracket $0 – $9,525
12% tax bracket $9,526 – $38,700
22% tax bracket $38,701 – $82,500
24% tax bracket $82,501 – $157,500
32% tax bracket $157,501 – $200,000
35% tax bracket $200,001 – $500,000
37% tax bracket $500,001 and above

2018 Long Term Capital Gains and Qualified Dividends Tax Rates for Single Taxpayers

0% tax bracket $0 – $38,599
15% tax bracket $38,600 – $425,800
20% tax bracket $425,801 and above

Standard Deductions

For dependents with only unearned income, the standard deduction is $1,050.

For dependents with earned income, the standard deduction is the greater of: 1) $1,050, or 2) earned income plus $350, not to exceed $12,000.

For nondependent single taxpayers, the standard deduction is $12,000.

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