The new tax law overhauls the U.S. tax code in a scale and proportion not seen in more than 30 years. Navigating it will require skill and finesse.
While the law will have a profound impact on both businesses and individuals – it slashes the corporate tax rate, eliminates the corporate alternative minimum tax and doubles the lifetime estate and gift tax exemption, just to name some of its provisions – what’s less clear is how businesses and individuals should respond to the legislation, and when. Many of the provisions expire after 2025 and many more require additional guidance from authorities.
‘Once in a Generation’ Tax Law
The historic new tax law has been characterized as a sweeping overhaul of the U.S. tax code—something in scale and proportion not seen in more than 30 years. Signed into law in late December 2017, the 1,000-plus-page bill—informally known as the Tax Cuts and Jobs Act
—ushered in significant changes to the Internal Revenue Code (IRC) on par in magnitude with the Tax Reform Act of 1986. In the months leading up to the TCJA’s passage, President Donald J. Trump called it “a once-in-a-generation opportunity.” While characterizing the TCJA as an “opportunity” is subject to debate, few would argue the law’s scope makes it the first of its kind in a generation. Woven into the massive new law are intricate provisions that impact the economic life of a wide range of seemingly discrete, yet interwoven entities, spanning real estate
, manufacturing, distribution
, and other commercial enterprises
, as well as high-net-worth individuals
. The TCJA’s varying provisions reach, in often overlapping ways, across the operations of each of these groups—a reality that suggests implementation in one area could impact the outcome in another. In short, the consequences of any overarching tax strategy will be determined by smaller, more nuanced responses to varying provisions, across each of these sectors. The law’s most significant changes to the IRC have by now been widely reported. Beyond eliminating the corporate alternative minimum tax, the corporate tax rate has been cut from 35 to 21 percent. For many of the U.S. businesses that operate as pass-through entities, the TCJA provides for up to a 20 percent deduction on qualified business income (QBI). In a measure that touches the operations of, among others, real estate, manufacturing, and distribution, the law allows far more expansive expensing and “bonus” depreciation provisions for capital improvements. The law also doubles the lifetime estate and gift tax exemption from $5.6 to $11.2 million, as adjusted for inflation, for individuals and from $11.2 to $22.4 million for married couples. These new provisions have varied implications for estate and income tax planning purposes. Because many of the tax provisions outlined expire after 2025, and because guidance is still needed with respect to several new rules, it’s uncertain how quickly entities and individuals should respond to the varying new measures. Though some scenarios may warrant a wait-and-see response, a strong case can be made for an emphasis on forecasting and modeling to better prepare for the law’s potentially widespread impact. Finding the best balance in any strategy is the critical challenge facing closely held businesses and individuals alike. The key questions are where and when planning should begin. Tax Law Longevity: Murky Crystal Ball Before implementing any action plan, it’s important to understand which areas of the law may potentially compromise more permanent tax planning strategies. Some elements of the tax bill are clear enough and may justify swift action. Others reveal a pressing need for guidance through yet-to-be instituted rules and regulations. That reality calls into question the long-term benefits of undertaking almost any immediate restructuring effort and suggests the potential wisdom of waiting for clarification. “There’s huge ambiguity, and uncertainty, with respect to many important provisions, which will have to be resolved at [several] stages,” said Steve Johnson, tax law professor at Florida State University College of Law. “There are over two dozen places in the 2017 Act in which there is express direction to Treasury to write regulations necessary to the implementation of the section. There’s already a backlog of regulations,” he said. Further guidance is necessary, for instance, in relation to Section 199A—the new section of the IRC that provides a 20 percent deduction on QBI for pass-through entities, such as partnerships, limited liability companies taxed as partnerships, and S corporations, along with sole proprietorships. While the section outlines limitations to the deduction, it instructs the secretary of the Treasury to prescribe regulations necessary to “carry out the purposes” of the law. That express call for guidance raises numerous questions on the immediate planning front. “This law was drafted quickly and it shows,” said Edward Zelinsky, a tax law professor at Yeshiva University’s Cardozo School of Law.21 “In particular, it is not clear whether Section 199A will be interpreted to require partners to receive appropriate guaranteed payments (taxed at regular income tax rates) or whether partners will be able to make all trade/business income qualify for the 20 percent deduction by structuring such income as partnership earnings, rather than guaranteed payments.” The ambiguities don’t stop there. “What sorts of businesses will be considered ‘specified services,’ and thus ineligible for the qualified business income?” said Daniel Hemel, assistant professor of law at the University of Chicago Law School. Such questions were recently echoed by the American Institute of Certified Public Accountants, which issued a letter that included the “specified services” qualifications among 39 areas in need of “immediate guidance” from the IRS and the Treasury Department. The letter also called for clarity in relation to “cash flow, entity structure, retirement, wealth transfer, and a vast number of other tax planning issues.” As tax strategists and clients wait for greater clarity on the law, another equally relevant question comes into play: How long can the law be counted on to stay in effect—and how can entities and individuals plan accordingly in the meantime? “You can guarantee the pendulum will swing in American politics. When that does happen, the [other party] will try to undo these provisions, it’s a certainty,” Johnson said. Absent two ingredients in the law—“simplification and stability,” as Johnson said—closely held businesses and individuals alike are wise to wonder, what steps should be taken now, and which deferred? Intricate Limitations for Real Estate
When a historic tax bill is signed into law by a real estate mogul-turned-president, it may be tempting to assume the resulting provisions will include generous real estate handouts. Closer inspection of the new law, however, reveals this is no free-for-all. Certainly, real estate professionals, like other commercial enterprises, were pleased with a potential pass-through deduction of 20 percent and enhanced bonus depreciation for capital improvements. These “breaks,” they assumed, would offset the bill’s “less favorable” aspects, such as a $10,000 cap on deductions for state and local income taxes, as well as sales and property tax. However, numerous limitations abound. Interest deduction limitations are one case in point. The law allows businesses, irrespective of form, to deduct net interest expenses only up to 30 percent of the “adjusted taxable income” for the year (the excess may be carried forward). Between now and 2021, the adjusted taxable income is calculated by adding back the amount of deductions for interest, depreciation, amortization, and depletion. For tax years beginning after Dec. 31, 2021, however, no addback will be permitted—some real estate professionals, for example, may face limitations on interest expense deductibility. Interest deduction limitations are one case in point. The law allows businesses, irrespective of form, to deduct net interest expenses only up to 30 percent of the “adjusted taxable income” for the year (the excess may be carried forward). Between now and 2021, the
adjusted taxable income is calculated by adding back the amount of deductions for interest, depreciation, amortization, and depletion. For tax years beginning after Dec. 31, 2021, however, no addback will be permitted—some real estate professionals, for example, may face limitations on interest expense deductibility. There are additional exceptions to the interest deduction rule, touching both real estate and commercial enterprises. If entities seek exemption from the limitation altogether, citing average annual gross receipts of less than $25 million, under the new tax law, they won’t just need to average gross receipts from the previous three years to prove exemption. They must also review ownership structures and gross receipts of partners and affiliates—a potentially Sisyphean task if partners include institutional vehicles such as real estate investment funds. Among highly leveraged entities, the new deductibility limits also trigger fundamental questions on the life cycle of real estate investment financing. If the interest on mezzanine financing is not tax-deductible, for instance, is the logical next step to seek private equity? That choice comes with its own heady tax considerations. Further Limitations to Enterprises
Beyond the interest deduction limitation, enterprises across industries are paying close attention to the 20 percent deduction—the much-reported tax break offered to pass-through entities and sole proprietorships that balances what many saw as preferential tax treatment of corporations under the new tax law. Who exactly qualifies for the 20 percent deduction between now and the provision’s end in 2025 is still not entirely clear. A business owner might easily assume that if he or she made $1 million, the ensuing tax liability would only be on $800,000 of pass-through income. Yet the tax law outlines what the law itself calls several “limitations,”33 based on the actual definition of “qualified business income”—specifically, for individual owners with taxable income above $157,500 ($315,000 if fi ling jointly as a couple), a W-2 limitation comes into play, whereby the deduction cannot exceed the greater of his shares of 50 percent of an entity’s W-2 wages, or the sum of 25 percent of wages, plus 2.5 percent of the original cost of assets subject to depreciation. In practical terms, newer real estate projects with significant original cost may receive the full benefit of the 20 percent deduction, depending upon whether the 2.5 percent of the original cost exceeds the 20 percent amount. However, older real estate, such as family-owned properties, which may have had minimal or insignificant capital improvements, and lack a high cost, will find that the 2.5 percent doesn’t go very far. Real Estate Impact
Two properties generate $1 million each in annual taxable income. So wouldn’t they both qualify for the same 20% deduction, or $200K? Not necessarily, when factoring in the limitation based on 2.5% of cost. Consider this breakdown*: Scenario 1:
‘Entity A’ purchased ‘Building A’ in 2015 for $10 million. The owners of Entity A could realize a deduction, based upon cost, of approximately $250K (0.025 x 10,000,000). Scenario 2:
Entity B purchased ‘Building B’ (similar to ‘Building A’) in 2005 for $5 million. The owners of Entity B could realize a deduction, based upon cost, of approximately $125K (0.025 x 5,000,000). Conclusion:
The owners of Entity A would potentially realize the full 20% deduction from the $1 million income; while the owners of Entity B are limited to a deduction of $125K. * Most real estate entities have little to no W-2 wages. For the purposes of this exercise, calculations focus exclusively on 2.5% of the cost basis.
Another area of minutiae is the law’s limitations on business (including real estate) losses. Whereas active real estate investors previously had no limits on real estate losses to offset other types of income—such as investment income, and dividends—the TCJA now limits business losses, including losses from pass-through entities and losses realized by sole proprietorships that can offset such income to $500,000 (for married taxpayers) or $250,000 (for individuals). In assessing implications, this new rule suggests that if an active real estate investor incurs $10 million in real estate losses in 2018, he or she may only be able to offset $500,000 of wages, investment income, and dividends. In 2017 and in prior years they would have been able to use the entire $10 million. This is potentially a big difference that may require additional guidance and/or restructuring. In addition, while the code in effect prior to 2018 allowed net operating losses to be carried back to the two preceding tax years, the new law only allows an NOL carryforward— itself further limited, in any given year, to 80 percent of taxable income. New Impacts on Manufacturers and Distributors
Manufacturers and distributors face their own unique provisions. The new tax law repeals the more narrow 9 percent deduction on goods produced stateside, in favor of new, and far broader, deductions. Beyond retaining the R&D tax credit, as well as the addition of rules regarding the repatriation of foreign earnings, the new law provides a bonus depreciation provision that goes well beyond that in the previous law, which was at 50 percent of the basis for new property only. The new provisions potentially allow bonus depreciation at 100 percent of the cost of eligible new or used property, retroactively implemented for assets acquired and placed into service Sept. 28, 2017 through Dec. 31, 2022. Equally significant is the provisions’ applicability to property that need only be “new to the taxpayer,” and, not purchased from a related person or entity. The finite five-year window may justify immediate action on the equipment purchasing front. Beyond that period the ability to deduct equipment purchased will be limited by gradually decreasing phase-outs—80, 60, 40, and 20 percent, respectively—until the provision ultimately expires
after Dec. 31, 2027. Until then, the opportunity for immediate expensing of certain fixed asset additions, or
capital improvements, may significantly drive down taxable income42—precisely because there’s now an immediate expensing opportunity of items that were previously capitalized. Estate Planning: Act Now?
While some of the law’s provisions on commercial enterprises may justify a delayed response, estate planning probably warrants more immediate action. The sizably increased exemptions, for both individuals and couples, are scheduled to sunset after Dec. 31, 2025. Yet as the estate tax repeal of 2010 demonstrated, no guarantee exists that current exemptions won’t be lifted sooner—if and when a new Congress comes into office. Even if the exemptions remain intact until 2025, however, this may not justify complacency. For example, if a high-net-worth individual with $6 million in assets (well below the $11.2 million exemption) failed to heed the eventual sun-setting of the new exemptions and died thereafter, the $6 million estate would then be taxable above the $5.6 million (adjusted for inflation) estate tax exemption that kicks back in. More immediately, while a clawback possibility is a common concern among high-net-worth individuals as they mull estate planning options, any measure would likely be met with the same opposition that greeted regulation Section 2704—the proposed limitations on valuation discounts for estate, gift, and generation-skipping transfer tax measures. The new tax law provides additional ways to transfer wealth across generations, as with 529 plans. The college-savings plan has since been expanded to cover K-through-12 education.47 While not all states have updated their respective laws to comport with the new federal law, there appear to be few, if any, drawbacks to making contributions now. Other areas of asset management, however, may require greater circumspection. For those over
age 70 ½, facing a traditional individual retirement account (IRA) and its withdrawal deadline, there also are questions about how to offset the tax law’s stricter limitations on itemized deductions. The law’s qualified charitable deduction may present a partial answer, allowing an IRA holder to transfer up to $100,000 a year, per individual, from an IRA directly into a charity. For others more concerned with ways to grow their investments, versus drawing them down, the new law is less flexible: Whereas past law allowed investors to roll over funds from a traditional IRA into a Roth, with the option to switch back based upon a change in value, the new law provides no such provision. While such particulars warrant careful review, the law still holds far greater certainty on the individual estate planning front, justifying, in many cases, a swift response. Conclusion
It would be easy enough to advocate a judicious, wait-and-see approach to a law as sweeping and expansive as the Tax Cuts and Jobs Act of 2017. Few of its provisions come without uncertainty, such as the 20 percent pass-through deduction and the many limitations that accompany it. Amid such intricacies, no one element of the law should be read in isolation. All approaches cannot be implemented with the same degree of speed or consideration, across all scenarios. While estate planning may warrant a swifter approach, for example, the income tax side may in some cases be better served by a more comprehensive review of restructuring options— particularly as the Treasury metes out new regulations and other guidance to clarify the law. Simply put, any response to the new tax law requires thorough modeling and forecasting strategies, particularly among corporations and pass-through entities, as they assess both state and federal income tax consequences for their entities under the new law. The longer one waits to model potential scenarios, the less benefit they may obtain from the new tax law. In this season of reflection, modeling all potential scenarios—such as the trade-off between interest deduction limitations and alternative depreciation, among any number of factors—will only grow in importance. That urgency will accelerate, not only as the clock starts ticking on sun-setting provisions, but also with changes that any new Congress may enact upon taking office. Now is thus the time to assess all options, so when more rigorous or even changing guidelines do ultimately emerge, businesses and individuals alike will be prepared to maximize tax cut benefits—not in a hurried, last-minute response—but through a measured, deliberate strategy that thoroughly assesses all possible scenarios.