Memorandum To: From: AAO Board of Trustees and Council on Government Affairs Arnold & Porter Kaye Scholer Date: December 22, 2017 Re: Analysis of New Tax Reform Law This memo is intended for use by the AAO Board of Trustees and the AAO Committee on Government Affairs for educating AAO members about the details of the new tax reform law. As the AAO s federal lobbying team, Arnold &Porter Kaye Scholer does not represent individual orthodontists, and the information below does not constitute the firm providing any individual member of the AAO with legal advice on how the new tax law affects their personal financial situation. We strongly recommend that all AAO members be in contact as soon as possible with their own accountant and legal counsel about the new tax law. It is possible some changes in the law create conditions where individuals and partnerships/corporations have incentive to accelerate select financial decisions into the final days of 2017 Examples might include, but not be limited to, prepaying Q4 2017 state taxes (due January 15, 2018) before the end of the year, prepaying local 2018 property taxes if allowed, and accelerating some planned charitable giving in 2018 to take advantage of the deduction versus 2017 s higher tax rate. We recognize that this is the most comprehensive tax law rewrite that has occurred during the professional careers of most AAO members. The short time frame for Congressional debate and passage of this law has created confusion on many levels, and it will take some time for all the answers to emerge. For those reasons, we again encourage you to make time to talk with your tax preparer about the impact of the new law on your personal situation. Legislative Background On Wednesday, December 20, the House passed the Tax Cuts and Jobs Act (TCJA) by a vote of 224 to 201. The Senate passed the legislation on a party-line vote of 51 to 48 late Tuesday night after the Senate parliamentarian found that a few minor provisions tucked Arnold & Porter Kaye Scholer LLP 601 Massachusetts Ave., NW Washington, DC 20001-3743 www.apks.com
into the bill violated Senate rules. As a result, the House was required to vote again on the bill that emerged out of the Senate chamber. On December 22, President Donald Trump signed the bill into law. Provided at the bottom of this memo is a chart showing all of the major legal changes in the TCJA. This memo provides an analysis of the TCJA s changes to the treatment of certain business income earned by non-corporate taxpayers, including sole proprietors, partners, S corporation shareholders, and trusts and estates. The TCJA makes significant changes to the business income tax system, which taxes ordinary income earned by partners, S corporation shareholders, and sole proprietors at individual income tax rates. Again, we have included a chart that tracks many of the key provisions of the final bill relevant to AAO members. Pass-Through Taxation With respect to the treatment of qualified business income, the TCJA generally followed the Senate version with a few significant modifications, which we summarize below. In addition, we also have provided two hypothetical examples to help AAO s member organizations conceptualize these new rules. The TCJA provides for a 20 percent deduction (against taxable income) of (1) domestic qualified business income (which does not include wages or guaranteed payments, among other categories of income), with respect to a qualified trade or business, from a partnership, S corporation, or sole proprietorship (subject to limitations described below), and (2) aggregate qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income. Generally, for taxpayers with taxable income in excess of an annual threshold amount (starting at $157,500 for single filers, and $315,000 for joint filers), the 20 percent deduction is limited by the greater of: (a) 50 percent of W-2 wages, or (b) 25 percent of W-2 wages, plus 2.5 percent of the unadjusted basis (as determined immediately after acquisition) of tangible depreciable property of the qualified business. For this purpose, W-2 wages is defined as the sum of wages subject to wage withholding, elective deferrals and deferred compensation paid by the partnership, S corporation, or sole proprietorship during the tax year. Property qualifying for the 2.5 percent limit is subject to several requirements not discussed in detail here. Please note that AAO member organizations who are organized as partnerships or S corporations are - 2 -
subject to special rules for purposes of determining certain limitations with respect to their partners and shareholders, respectively. A taxpayer who is involved in a specified service trade or business and whose taxable income exceeds the applicable threshold amounts referenced above generally will be precluded from claiming the 20 percent deduction with respect to income derived by that specified service trade or business. AAO s member organizations are likely to fall within the TCJA s definition of a specified service trade or business. Therefore, if an individual, partner, or shareholder of an AAO member organization earns more than $207,500 of taxable income as a single filer or $415,000 as a joint filer (the fully phased out threshold amounts for this purpose), they generally will not be able to claim the 20 percent deduction with respect to their allocable income from such business. AAO Member Examples on Pass-Through Taxation Below are two hypothetical examples to illustrate, in a general manner, how the TCJA s qualified business income provision would work. 1. In 2018, an individual provides dental care to patients as a sole proprietor. The individual earns $150,000 of taxable income from all income sources. All of this amount is taxed as ordinary income. Although the individual s business falls within the TCJA s definition of a specified service trade or business, the individual s income for 2018 is below the threshold amount for a single filer. Thus, the individual would be eligible to claim the 20 percent deduction against taxable income for 2018. Furthermore, because the individual s 2018 income is below the threshold amount, the individual is not subject to any limitations on the 20 percent deduction. 2. In 2018, an individual is a partner in a partnership that provides dental care to patients. The partner earns $500,000 annually from all income sources. All of this amount is taxed as ordinary income. The partnership s business falls within the TCJA s definition of a specified service trade or business and the partner s 2018 income exceeds the threshold amount for a single filer. Thus, the partner is ineligible to claim the 20 percent deduction for 2018. - 3 -
Tax Cuts and Jobs Act Summary Chart Provision Old Law New Law Sunset of Individual Tax Changes Individual Provisions After 2025, almost all of the changes made with respect to the individual income tax system would end and the tax rules would revert to the law that existed prior to January 1, 2018. Therefore, the provisions that are added or repealed in the individual tax code are temporary. Individual Rates Standard Rate Single Joint 10% $0 - $9,525 $0 - $19,050 15% $9,526 - $38,700 $19,051 - $77,400 25% $38,701- $93,700 $77,401 - $156,150 28% $93,701 - $195,450 $156,151 - $237, 950 33% $195, 451 - $424,950 $237,951 - $424,950 35% $424,951 - $426,700 $424,951 - $480,050 39.6% $426,701 and over $480,051and over This would have been the tax bracket for 2018 under current law. Standard deduction: $6,500 for Single Filers $9,550 Head of Household $13,000 Married Filing Jointly Notably, if the provisions are indexed for inflation, they will continue to be indexed albeit by applying chained-cpi. Rate Single Joint 10% $0 - $9,525 $0 - $19,050 12% $9,526 - $38,700 $19,051 - $77,400 22% $38,701- $82,500 $77,401 - $165,000 24% $82,501 - $157,500 $165,001 - $315,000 32% $157, 501 - $200,000 $315,001 - $400,000 35% $200,001 - $500,000 $400,001 - $600,000 37% $500,001 and over $600,001 and over Roughly doubles the standard deduction: $12,000 Single Filers $18,000 Head of Household $24,000 Married Filing Jointly
Personal/ Dependent Exemption Individual Mandate Child Tax Credit Alternative Minimum Tax The current code also offers a $4,150 per-person standard deduction along with an additional standard deduction of $1,300 for the aged or blind ($1,600 if unmarried). $4,150 standard exemption per person, indexed for inflation. Imposes a penalty of $695 or 2.5 percent of income (with a deduction), whichever is higher, for those who do not have health insurance. Provides a partially refundable $1,000 child tax credit for the first two children, with a less generous additional child credit for third and subsequent children. Exemption amounts of $54,300 for single filers; $84,500 for married filers. Income threshold above which the Alternative Suspended for 2018-2025. Repealed. Provides a partially refundable $2,000 credit per qualifying child under the age of 17. The refundable portion of the child tax credit requires a SSN and is capped at $1,400 (indexed for inflation). Phase out starts at $200,000 for single filers and $400,000 for joint filers. Provides $500 nonrefundable credit for qualifying dependents other than qualifying children. Difference between refundable and nonrefundable tax credits: Taxpayers subtract both refundable and nonrefundable credits from the taxes they owe. If a refundable credit exceeds the amount of taxes owed, the difference is paid as a refund. If a nonrefundable credit exceeds the amount of taxes owed, the excess is lost. Thus, more lower-income families will benefit as a result of the increase in the refundable portion of the credit to $1,400. Increases exemption amounts to $70,300 for single filers; $109,400 for married filers. Income threshold above which the Alternative Minimum Tax
Estate Tax Capital Gains & Dividends Carried interest State and Local Tax Medical Expense Mortgage Interest Minimum Tax exemption phases out is $120,700 for single filers; $160,900 for joint filers. Imposes an estate tax of $5 million indexed for inflation after 2011. In 2017, the estate tax exemption was approximately $5.5 million. Long-term capital gains and qualified dividends are taxed at special rates of 0, 15 and 20 percent, depending on the taxpayer s taxable income. ACA 3.8% net investment income tax remains unchanged. Allows individuals to fully deduct real estate, personal property, and either income or sales tax. Medical expense deduction if meeting floor of 10% of adjusted gross income. limited to $1 million in mortgage debt and $100,000 in equity debt. exemption phases out is increased to $500,000 for single filers; $1 million for joint filers. Doubles estate and gift tax exemption amount from $5 million to $10 million, indexed for inflation after 2011. In 2018, the estate tax exemption will be doubled from approximately $5.6 million to $11.2 million for single filers and $22 million for joint filers. Unchanged, but because the 37% tax bracket is increased to $500,001 for single filers and $600,001 for joint filers, more taxpayers qualify for the 15% rate. Please note that this change would end after 2025. If partnership interest is received in exchange for services, taxpayer must hold interest for at least 3 years to benefit from long-term capital gains rate with respect to the partnership interest. Allows state and local tax deduction of up to $10,000. Taxpayers have the ability to combine property plus choice of income or sales taxes up to the full amount of the $10,000 deduction. During tax years 2017 and 2018, the medical expense deduction s floor would be 7.5% of adjusted gross income. After 2018, the 10% adjusted gross income floor would be applicable. Reduces limit on deductible mortgage debt to $750,000 for new purchases and refinancing (principal residence or otherwise) entered into after December 15, 2017. Repeals deduction for interest paid on home equity debt, through December 31, 2025. Preserves deduction for second home.
Charitable Miscellaneous Expense Electric Vehicle Tax Credit Deductible as an itemized deduction up to 50% of income. Deductible as an itemized deduction up to 60% of income for tax years 2018 through 2025. Suspends through 2025 all miscellaneous itemized deductions subject to the 2% floor. No change. Corporate Tax Rate Corporate Alternative Minimum Tax Pass-Through Tax Rate Business Provisions A top marginal rate of 35% and a bubble rate of 39%. Reduced to 21% after 2017. 20% rate for a more broadly defined alternative definition of income. Pass-through income is taxed as ordinary income, subject to the individual s tax rate. Repealed. Would allow 20% deduction through 2025 for pass-through income (including trusts and estates), limited to the greater of (a) 50% of wage income with respect to the qualified business or trade or (b) the sum of 25% of wage income with respect to the qualified business or trade plus 2.5% of the unadjusted basis of all qualified property (which is determined immediately after an acquisition). Wage income is defined as the sum of wages subject to wage withholding, elective deferrals and deferred compensation paid by the partnership, S corporation, or sole proprietorship during the tax year. For trusts and estates, to calculate the apportionment between fiduciaries and beneficiaries of any wage income and unadjusted basis of any qualified property, rules similar to Section 199 would apply. The deduction does not apply to "specified service businesses," except for taxpayers whose taxable income does not exceed
$207,500 for individuals; $415,000 married. The benefit of the deduction is phased out for these taxpayers over a $50,000 range ($100,000 if joint return) for taxable income exceeding the $157,500 for individuals, and $315,000 if married filing jointly. Expensing for Certain Assets Net Operating Losses (NOL) Interest s Credit for Paid Family and Medical Leave Allows 50 percent bonus depreciation for short-lived capital investment placed into service before 2018; 40 percent for eligible property placed into service prior to 2019; 30 percent prior to 2020. Property placed in service is the point in time when an asset that can be depreciated is first placed in use. The date the asset is placed in service marks the beginning of the depreciation period. The proposal defines services businesses to include any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation of skill of one or more of its employees. It does not include engineering or architecture trades or businesses. Full expensing for property placed in service after September 27, 2017, but begin to phase down the percent that may be expensed for property placed in service after Jan 1, 2023, by 20% every year. In 2023 expensing would be limited to 80%; 2024, 60%; 2025, 40%; 2026, 20%. Definition of qualified property is expanded to include used property. Eliminates NOL carrybacks while allowing indefinite NOL carryforwards, limited to 80% of the taxpayer s taxable income. Caps the deduction for net interest expense to 30% of earnings before interest, depreciation, amortization (EBITDA) for four years, and 30% of earnings before interest and taxes (EBIT) thereafter. Establishes a credit during a two-year period that would permit eligible employers allowing full-time employees at least two weeks annual paid family and medical leave to claim a business credit.
Charitable Contributions Education & Tax Exempt Provisions Deductible as an itemized deduction up to 50% of income. However, 20% and 30% limitations apply in some cases. Increases the limitation for cash contributions to public charities and certain private foundations from 50 to 60 percent for contributions made before 2026. College Athletic Seating Student Loan Discharges Income Exclusions related to Education - Qualified Tuition Reductions Income Exclusions related to Education - Allows taxpayers to deduct as a charitable contribution 80 percent of the amount paid for the right to purchase tickets for athletic events at a college or university stadium. Gross income generally includes the discharge of indebtedness of the taxpayer. Under an exception to this general rule, gross income does not include any amount from the forgiveness of certain student loans, provided that the forgiveness is contingent on the student s working for a certain period of time in certain professions for any of a broad class of employers. Private loans are not eligible for discharge. Repeals the charitable contribution substation exception for contributions reported by donee organization. Repeals the special rule allowing taxpayers to deduct as a charitable contribution 80 percent of the amount paid for the right to purchase tickets for athletic events at a college or university stadium. Excludes from gross income the discharge of student debt on account of death or total disability and modifies the gross income exclusion for amounts received under the National Health Service Corps loan repayment program or certain State loan repayment programs. Applies to discharges of loans after December 31, 2017 and through December 31, 2025. No change. No change.
Interest on U.S. Savings Bonds Income Exclusions related to Education - Employer- Provided Education Assistance Rollover Allowances for Qualified ABLE Programs No change. Allows for amounts from 529 accounts to be rolled over to an ABLE account without penalty, if the ABLE account is owned by the designated beneficiary of that 529 account, or a member of such designated beneficiary s family. This provision also is in the House bill. The provision would expire at the end of 2025. Increases the limitation to ABLE accounts (currently $14,000) for contributions made by the designated beneficiary of the ABLE account only. Would require that a designated beneficiary, or a person acting on behalf of the designated beneficiary, maintain adequate records to ensure that additional ABLE contributions do not exceed the lesser of the federal poverty line for a one-person household or the individual s compensation for that tax year. The designated beneficiary, or a person acting on the designated beneficiary s behalf would also be obligated to ensure compliance with other limitations. Allows a designated beneficiary of an ABLE account to claim the saver s credit for contributions made to his or her ABLE account.
Higher Education Tax Credits No change. Endowments Imposes a 1.4 percent excise tax on private colleges and universities that have (1) at least 500 students and (2) assets valued at a minimum of $500,000 per full-time student during the preceding tax year. Endowment assets that are formally held by organizations related to the university, and not merely those that are directly held by the university, also are subject to the tax. Moving Expenses Moving Expenses (Qualified) Research Expenditures Clarifies the provision applies only to assets held for the educational institution and to investment income that relates to assets held for the educational institution. An additional modification is made to only include those institutions for which more than 50 percent of the tuition-paying students are located in the U.S. Suspends the deduction for moving expenses through 2025, except for exclusions for certain in-kind moving and storage expenses for members of the Armed Forces and their spouse or dependents. Suspends the exclusion for qualified moving expense reimbursements through 2025, except for moving expenses of a member of the Armed Forces on active duty who moves pursuant to a military order. The conference bill adopts the Senate provision, which modified the House amendment. The House bill would have eliminated deductions for research or experimental expenditures, except for exploration expenditures (ore deposit or other minerals, including oil and gas), land or other property acquisition or improvement, and software development. Instead, it requires the expenditures to be capitalized and amortized over a 5-year period (15 years in the case of expenditures attributable to research conducted outside of
the United States). The Senate bill adopted the House provision with the following modifications. Senate amendment is treated as a change in the taxpayer s method of accounting for purposes of sec. 481, initiated by the taxpayer and made with the consent of the Secretary. The Senate amendment is applied on a cutoff basis to research or experimental expenditures paid or incurred after December 31, 2025. Additionally, senate amendment makes conforming changes to sections 41 and 280C. Capital Investment (179 Expensing) Allows Section 179 small business expensing with a cap of $500,000 and a phaseout beginning at $2 million. Small Business Provisions Increases limit to $1 million, with a phaseout beginning at $20 million in total qualified property placed in service. Also expands qualified Section 179 property to include depreciable tangible personal property used furnish lodging and improvements to nonresidential real property (like roofs, heating, ventilation, air-conditioning, fire protection and alarm systems). Cash Method of Accounting Businesses with less than $5 million in income may use the cash method of accounting. Shortens the depreciation recovery period of real property to 25 years. Increases the average gross receipts threshold for corporations and partnerships with corporate partners that are not allowed to use the cash method of accounting from $5 million to $25 million.