TAX BULLETIN NOVEMBER 8, 2017

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1 TAX BULLETIN NOVEMBER 8, BMAJOR TAX REFORM BILL INTRODUCED: 1BWE ARE OFF AND RUNNING OVERVIEW The days of campaign proposals, blueprints, and frameworks are over. We now have a detailed tax bill introduced in the House of Representatives: the Tax Cuts and Jobs Act (HR 1). The bill, introduced on November 2, and already modified on November 3 rd and 6 th by the House Ways and Means Committee, proposes the most significant tax reform in over 30 years, affecting almost all individuals and entities subject to taxation, from individuals and passthrough entities, to domestic and international corporations. To be sure, there will be winners and losers on the personal income tax side. Generally, taxpayers residing in moderate to high income tax states with significant income could see higher federal income taxes. This Bulletin summarizes and highlights important elements of the bill and its amendments (the House Bill ) and includes early observations on its effect for high-income/net worth taxpayers. This is only the beginning of the end. The House Bill will certainly be modified and tweaked. The Senate will also propose a tax bill that could be different in material respects. While it may be too early to take any action, taxpayers should begin to consider the implications of typical year-end decisions, such as selling capital assets and charitable giving, but await more clarity before taking action. INDIVIDUAL TAXES 1 Current Law0F 2 Unified Framework1F House Bill (HR 1)2F 3 Individual Tax Rates 10, 15, 25, 28, 33, 35, 39.6% 12, 25, 35%; additional unspecified top rate may apply to highestincome taxpayers 12, 25, 35, 39.6%; phase-out of 12% bracket for high-income taxpayers Standard Deduction $12,700 ($6,350 if single) $24,000 ($12,000 if single) $24,400 ($12,200 if single) Personal Exemption Top Capital Gains/Dividend Tax Rate $4,050, subject to phase-out ; merged with higher standard deduction 20% (plus 3.8% surtax) Unspecified and therefore assumed unchanged ; merged with higher standard deduction Current maximum rate is retained

2 INDIVIDUAL TAXES (continued) Itemized Deductions Up to 80% of most itemized deductions are lost when adjusted gross income exceeds $313,800 ($261,500 for single taxpayers), except for mortgage interest and charitable contributions Repeals overall limitation (Pease) on itemized deductions; Mortgage interest deduction: reduced from $1 million acquisition indebtedness to $500,000, limited to principal residence; Repeals deduction for state and local income or sales tax; real property taxes limited to $10,000; deduction allowed for state and local taxes on trade or business; and Repeals deduction for medical expenses Retirement Savings Up to contribution cap can be placed into deferred account Unchanged Unchanged AMT Parallel tax calculation with top rate of 28% Carried Interest Retains character as capital gain and eligible for preferential tax rates Unspecified, but likely recharacterized as ordinary income3f 4 Requires three-year holding period to attain long-term 5 capital gains rate4f Investment Surtax 3.8% Unspecified (and likely retained) Unchanged OBSERVATIONS INDIVIDUAL TAXES Under the House Bill, there will be winners and losers on the personal income tax side. Generally, taxpayers who could see a lower tax bill will be wage earners from no-tax states5f6. For instance, a Florida taxpayer earning $1 million with moderate itemized deductions may see a tax savings of about $27,000, but a similar taxpayer in New York State may see almost no change, according to our preliminary analysis.6f7 Conversely, taxpayers who will see a higher tax bill will be very high-wage earners from high-tax states. Such a taxpayer earning $2 million in New York State may see a significant tax increase ($38,000) due in part to the loss of significant deductions and a surtax from the phase-out of the lowest tax bracket, while a similar taxpayer in Florida would see a tax savings of about $13,000, according to our preliminary analysis.7f8 Estimates from the Joint Committee on Taxation (official scorekeeper for tax legislation) indicates that 76% of taxpayers with income over $1 million would see a tax cut; the remaining 24% will see a tax increase. Those seeing a tax increase will likely be taxpayers in high-tax states. It appears that state of residence, type of income (wages versus new qualified business income ), and home ownership will be among the most important factors for determining whether one is better or worse off under the House Bill. 2

3 WEALTH TRANSFER TAXES Estate Tax 40% rate, $5,490,000 exemption (indexed for inflation) Commencing 2018, exemption for estate tax doubled from $5.6 million to $11.2 million (indexed for inflation) Gift/GST Tax Tax Basis Upon Death 40% rate, $5,490,000 exemption (indexed for inflation) Unknown/eliminates Beginning in 2024, estate tax repealed Commencing 2018, exemption for gift and GST tax doubled from $5.6 million to $11.2 million (indexed for inflation) Beginning in 2024, GST tax repealed; gift tax lowered to 35% with $11.2 million (indexed) exemption Full step-up for most assets Unknown Same as current: Step-up for estate property, whether or not subject to estate tax OBSERVATIONS WEALTH TRANSFER The wealth transfer tax proposals in the House Bill would represent a dramatic change to our transfer tax system. As stated, there would be a doubling of the exemptions until 2024, at which time there would be estate and GST tax repeal. The gift tax would remain. The step-up in basis at death would continue, both before and after the estate tax repeal. These provisions would have a significant effect on both testamentary and lifetime estate planning. Testamentary planning. Given the uncertainty of whether the estate tax would be effective or repealed at a person s death, it may be advisable for wills and other testamentary documents (such as revocable trusts) to contain alternate provisions. Documents could provide for one set of dispositions in case the estate tax is in effect and another set in case there is estate tax repeal. As always, documents should be drafted with flexible provisions that can be adjusted for future changes. If the estate tax is repealed, repeal may only be temporary. Even if estate tax repeal is permanent, the estate tax could always be reinstated by future legislation. Lifetime planning. Lifetime gifts are often made to reduce the estate tax that would otherwise be incurred at death. This analysis should also take into account any capital gains tax, if assets are sold. This analysis can be done if you can reasonably determine what the estate tax and basis step-up rules would be at death. Since there is uncertainty whether the estate tax will be repealed at a person s death, or whether there will be a basis stepup, the tax consequences of making a current gift may have to be compared with at least 3 possible estate tax scenarios: (1) Estate tax and basis step-up, as under current law; (2) Estate tax repeal and basis step-up, as under the House Bill; and (3) Estate tax repeal and carryover basis, as might be the case if estate tax repeal and basis step-up is too expensive. This will obviously make planning more challenging, because you are comparing multiple scenarios, and there may likely be inconsistency as to which strategy achieves the best result. 3

4 CORPORATE TAXES Top C-Corporate Rate 35% 20% --methods to reduce the double taxation of corporate earnings may also be considered 20% (personal service corporations subject to a 25% rate) AMT Parallel tax calculation with top rate of 20% Aims to eliminate Business Investments Limited immediate expensing; balance subject to depreciation Immediate expensing for cost of new investments in depreciable assets (other than structures) made after September 27, 2017, for at least 5 years Immediate expensing for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (with additional year for certain property) Interest Expense No limitation Deduction for net interest expense incurred by C- corporations will be partially limited Limited to 30% of a business s adjusted taxable income; full deduction for small businesses with gross receipts of $25 million or less PASS-THROUGH ENTITY TAXES Top Rate: Pass-Through Entities (S-corporations, LLCs, LLPs and Partnerships) /Sole Proprietorships Subject to tax at individual rates up to 39.6% 25% -- with measures to prevent recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top tax rate 25% rate for portion of net income treated as qualified business income, which is generally 30% of the net business income derived from active business activities, with remaining 70% subject to ordinary individual rates; May elect to apply a formula to determine a percentage greater than 30% for capital-intensive business; Passive owners generally entitled to 25% rate on all business income Pass-Through Entities Service Businesses Portion of net income treated as qualified business income, for service business (e.g. accounting, law, consulting, investing, etc.) generally 0%; May elect to apply a formula to determine a percentage greater than 0% for capital-intensive service business provided minimum capital is at least 10% 4

5 OBSERVATIONS PASS-THROUGH ENTITIES The House Bill fundamentally changes the taxation of many pass-through entities (sole proprietorships, partnerships, LLCs, LLPs and S-corporations) by allowing qualified business income to be taxed at a preferential rate of 25%. There would be no benefit for married taxpayers with taxable income below $260,000 (or single taxpayers below $200,000) because they would already be in a 25% or lower bracket for Taxpayers who are passive owners in a business would be eligible for the 25% rate on all their business income. However, taxpayers who are active owners would be eligible for the 25% rate on only a portion of their business income (generally 30%, but perhaps greater if the business is capital intensive). While upper-income wage earners in hightax states generally do not fare well under the House Bill, taxpayers with substantial income from pass-through businesses should see a tax benefit compared with current law, since the weighted average rate of business income would be approximately 35%8F9. Capital gains, dividends, and other preferential income from a business would not be considered business income and would continue to be taxed at preferential tax rates. Owners of service businesses (e.g., law, accounting, consulting, etc.) generally would not be eligible for the 25% rate, unless at least 10% of their business income is derived from capital (as determined by proposed tax rules), and then only to such extent. CORPORATE INTERNATIONAL TAXES International Corporate Tax Scope Worldwide with deferral available Territorial; 100% exemption for dividends from foreign subsidiaries (in which U.S. parent owns at least a 10% stake) 100% of foreign-source portion of dividends paid by foreign corporation to U.S. corporate shareholder (that owns at least 10%) would be exempt from U.S. taxation One-Time Deemed Repatriation of Foreign Earnings No Deemed repatriation of foreign earnings accumulated overseas subject to two unspecified tax rates (for cash and nonliquid assets) U.S. shareholders owning at least 10% of a foreign corporation would be taxed on post-1986 net foreign earnings and profits (12% on earnings and profits comprising cash or cash equivalents; 5% on remaining earnings and profits); may elect to pay tax over a period of up to 8 years, in equal annual installments OTHER PROVISIONS There are other provisions of note that are not included in the charts above. Roth recharacterization no longer allowed. Under current law, if you convert a traditional IRA to a Roth IRA, you can recharacterize that conversion within certain time limits, in effect undoing it. For tax years beginning after 2017, the House Bill repeals this rule, meaning you can no longer recharacterize a Roth conversion. From the current language of the effective date, it is unclear whether this would prevent a 2017 Roth conversion that has already occurred from being recharacterized in

6 Sale of principal residence exclusion. Under current law, up to $250,000 of gain ($500,000 if filing jointly) on the sale of a principal residence may not be taxed. Among the requirements is that the principal residence be owned and used as your principal residence for two out of the last five years. You can use this rule only once every two years. This exemption is available regardless of income. For sales after 2017, the House Bill makes three changes. First, the principal residence must be owned and used as your principal residence for five out of the last eight years. Second, you can use this rule only once every five years. Third, the amount of gain that can be excluded is phased out dollar for dollar for average modified AGI over $250,000 ($500,000 for joint filers) for the taxable year and two preceding taxable years. For joint filers, this means that if average modified AGI is $1,000,000, the exclusion is fully phased out and would not be available. Nonqualified deferred compensation. For nonqualified deferred compensation, generally you do not take that compensation into income until the year you receive it (and the employer s deduction is postponed until that time). This is true even if there is no risk that you might forfeit that compensation. That is, even if the deferred compensation is not dependent on future service, it is still the case that you will not be taxed on it until it is received (assuming that the other requirements of nonqualified deferred compensation, such as Section 409A, are satisfied). Under the House Bill, even if you have not received it, you are taxed on deferred compensation as soon as there is no substantial risk of forfeiture with regard to that compensation (i.e., receipt of the compensation is not subject to future performance of substantial services). This new rule would apply to deferrals attributed to service performed after For compensation already deferred, this will first apply in Like-kind exchanges. Currently real estate and personal property can qualify for a tax-deferred likekind exchange. (The property must be held either for investment or for use in a trade or business.) Under the House Bill, like-kind exchanges will be available only for real estate, not personal property. This will end, for example, like-kind exchanges of art. This new rule is effective for transfers after However, there is a transition rule to allow like-kind exchanges of personal property to be completed if you have either disposed of the relinquished property or acquired the replacement property on or before December 31, Savings Plans. Currently, funds in 529 Saving Plans can be used tax-free for higher education expenses. Under the House Bill, up to $10,000 per year could be used for elementary and high school tuition. Charitable Gifts. A charitable contribution deduction is currently limited to a certain percentage of the individual s adjusted gross income (AGI), and this limitation varies depending on the type of property contributed and the type of exempt organization receiving the property. In general, cash contributed to public charities, private operating foundations, and certain non-operating private foundations may be deducted up to 50% of the donor s AGI. Under the House Bill, this 50% limitation would be increased to 60%. The provision would retain the 5-year carryover period to the extent that the contribution amount exceeds 60% of the donor s AGI. Investment Expenses and Investment Interest. Not all itemized deductions are repealed. Without any explanation, the House Bill retains itemized deductions for investment interest expenses and 6

7 investment expenses. Under current law, investment expenses are deductible as a miscellaneous itemized deduction if, and to the extent, they exceed 2% of AGI. Without the AMT, this expense could be more meaningful for upper-income taxpayers. The deduction for investment interest also remains untouched and, as under current law, would be limited to investment income. CONCLUSION The path to tax reform is lined with political potholes, distractions and legislative hurdles. However, a unified Republican Congress and Republican Administration may provide a narrow path for tax law changes or even more sweeping reform. None will be easy; all will be controversial. However, without an understanding of the current law and the current proposals, year-end planning will be more difficult. While it is always best to plan based on actual law, rather than proposals, it is also wise to understand the implications that various proposals can have on your particular tax situation. National Wealth Planning Strategies 1 Inflation-adjusted amounts for The Unified Framework for Fixing Our Broken Tax Code was released by the Congressional Republicans and the White House on September 27, Tax Cuts and Jobs Act (HR 1), dated November 2, 2017, as modified by Chairman Brady and House Ways and Means Committee on Nov. 3 and 6, Although no detail was included in the September 27 Unified Framework, comments by the Administration appear to indicate the elimination of preferential tax treatment. 5 As amended by House Ways and Means Committee on November 6, There are nine states that impose no state income tax: AK, FL, NH, NV, SD, TN, TX, WA and WY (NH and TN impose a tax only on dividends and interest). 7 For illustration purposes, assumes the following itemized expenses: charitable gifts $10,000, real estate tax $30,000 (limited to $10,000 under the proposal), mortgage interest of $15,000, and appropriate state income taxes, where applicable. 8 A surtax on high-income taxpayers would be imposed by phasing out the lowest (12%) tax bracket. This would result in an additional 6% tax on income between $1,200,000 and $1,614,000 for married taxpayers, resulting in additional tax of up to $24,840. A similar rule applies to single taxpayers at different thresholds. 9 At least 30% of the business income would be taxed at a favorable 25% rate, and 70% of the business income would be taxed at rates up to 39.6%, resulting in a weighted average rate of about 35%. IMPORTANT: This publication is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy are dependent upon your individual facts and circumstances. Clients should always consult with their independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. Clients should consult with their legal and/or tax advisors before making any financial decisions. U.S. Trust operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC Bank of America Corporation. All rights reserved. NWPSHouseHR1 November