One happy consequence of the new tax law is that it should now be easier to plan for the alternative minimum tax. Fewer clients will owe it for 2018, according to Kleiman, in part because of the increase in the AMT exemption. Moreover, now that state and local tax deductions have been curtailed and miscellaneous itemizations scrapped, clients will have fewer deductions to add back to income under the alternative tax system, which helps prevent the tax from applying, Kleiman says.
Advisors should also put divorce planning on the list for the end of the year. Clients won’t be able to deduct any alimony paid under divorce or separation instruments executed after December 31, and alimony received under such instruments won’t be taxable.
Helping Business Clients
Tax reform set entrepreneurs alight when it drubbed the corporate tax rate from 35% to 21%. Many pondered converting their businesses into C corporations. But few have actually gone through with it, tax pros say. The lower rate “helps the big multinationals,” observes Mark Merric, an international business attorney in Denver. “But it doesn’t have much of an effect on the choice of entity for closely held businesses.”
A C corp only makes sense when a business “has a need to retain the earnings and doesn’t intend to distribute them,” says Minneapolis tax attorney Andrea Mouw, a principal in the national tax practice of Eide Bailly LLP. That means such structures are more appropriate for capital-intensive businesses, Mouw says. Otherwise, “the math just doesn’t work.”
Take a C corp earning $100. It will pay $21 in corporate tax. If the remaining $79 is paid out as a dividend, the shareholder could lose 23.8% to federal taxes (the maximum 20% tax on qualified dividends, plus the 3.8% net investment income tax), or $18.80. That works out to a 39.8% effective tax rate on distributed C corp profits, says Mouw’s colleague, Adam Sweet, also a principal in Eide Bailly’s national tax practice, in Spokane, Wash.
Meanwhile, owners of non-C corporation businesses, including sole proprietors, may be able to deduct as much as 20% of their qualified business income under new Internal Revenue Code Section 199A. This deduction could lower the highest tax rate on business profits to 29.6% (the 37% top individual rate times 80% taxable equals 29.6%). Sweet says, “The 20% deduction is a real game changer. Even if your deduction is limited, you’re going to beat the effective corporate rate of 39.8%.”
Still, the 20% deduction of business profits can be limited for any owner whose taxable income exceeds $315,000 when filing jointly with a spouse or $157,500 when filing single. Even worse, the deduction can be wiped out completely for clients with specified service businesses, including doctors, lawyers, accountants, investment managers and other professionals. These people are subject to a phase-out that eliminates the deduction once their taxable income reaches $415,000 on a joint return or $207,500 on a single filer return.
In addition to these service businesses, broad language in the tax act called for the deduction-killing phase-out to apply to any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners, Sweet notes. However, proposed Treasury regulations issued on August 8 limited this to mean income from endorsements or for the use of an individual’s image, name or likeness, as well as to appearance fees, including income paid to “reality performers performing as themselves on television, social media or other forums, radio, television, and other media hosts, and video game players.”
As the end of the year approaches, business clients have ample opportunity to maneuver their income below these or other important thresholds. Buying equipment, either new or used, and writing off the full cost immediately under tax reform’s 100% bonus depreciation is one way to lower business earnings.