Misunderstood Provisions of the New Tax Law Affecting High-Net-Worth Business OwnersBy Dawn Rhodes
March 20, 2018
Everyone is acutely aware of the Tax Cuts and Jobs Act (the Act) that was signed into law by President Trump on December 22, 2017. Although it’s hard to miss the glaring headlines surrounding some of the major new provisions, other changes that impact more limited groups of taxpayers are not receiving the same level of attention.
Many of these lesser known or misunderstood provisions will significantly affect high-net-worth individuals and their New Jersey businesses.
Limitation on 100% Bonus Depreciation
This provision allows many taxpayers to write off 100 percent of new and used qualifying property purchased in the last quarter of the year, but many taxpayers are not aware of the provision’s limitations.
The write-off is not permitted if the taxpayer had a written binding contract to purchase the property prior to September 28, 2017. If this is the case, prior tax law applies, which means that new property only qualifies for 50 percent bonus depreciation and used property does not qualify for any bonus depreciation at all.
The Internal Revenue Code (IRC) provides examples of what constitutes a binding contract under prior tax law, but further regulations will be needed to clarify how it will be determined under the new Act.
Clarification on Home Equity Loans
Under prior law, taxpayers could deduct qualified residence interest on mortgage debt up to $1 million plus interest on a home equity loan of up to $100,000. (For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence.) Interest on the home equity debt was deductible regardless of how the loan proceeds were used.
While the Act clearly limits the principal mortgage deduction to debt of $750,000, it was ambiguous about the deduction for home equity loan interest. The caption “Disallowance of Home Equity Indebtedness Interest” led most taxpayers to believe it was eliminated.
In February 2018, the IRS issued a release to clarify that the deduction is limited to interest on home equity loans and lines of credit that are used to buy, build or substantially improve the home that secures the loan. Therefore, the deduction no longer applies if the funds are used for personal or other expenses.
The release contained the following example: A taxpayer took out a $500,000 mortgage to buy a principal residence with a fair market value of $800,000 in January 2018. The loan is secured by the residence. In February, the taxpayer takes out a $250,000 home equity loan to pay for an addition to the home. Both loans are secured by the principal residence, and the total does not exceed the value of the home.
The taxpayer can deduct all the interest on both loans because the total loan amount does not exceed $750,000. If the home equity loan proceeds had been used to pay off student loans and credit card bills, however, the interest on that loan will not be deductible.
Accounting Methods for Small Businesses
The Act expands the ability for businesses with average annual gross receipts of $25 million or less to utilize a simpler method of accounting, such as the cash method. These taxpayers will not be required to apply the inventory or uniform capitalization rules and will not be required to use the percentage of completion method for small construction contracts.
The Act also provides that such a change in accounting method be treated as initiated by the taxpayer and made with the Secretary’s consent. The change will be automatic and, while subject to various qualifications, can usually be made on the taxpayer’s first return implementing the change. Effective for tax years beginning after December 31, 2017, this change can be made on 2018 tax returns for calendar-year taxpayers.
Impact on Business Entity Structure
While the change in corporate tax rates is one of the biggest pieces of news coming out of the Act, owners of S-corporations are uncertain about what this means for their corporate structure. Should they remain a pass-through entity or convert to a C-corporation to take advantage of the slashed rates?
A word of caution: history often repeats itself. Consider the Tax Reform Act of 1986 (TRA), which plunged the top individual rate from 50 to 28 percent. While the TRA reduced the corporate tax rate from 46 to 34 percent, it significantly limited the number of corporations that could benefit from the reduction. Due to the lower tax rate on pass-through income, C-corporations of all sizes were converting to S-corporations.
Fast forward to 1991. President Bush was president and, despite his “Read my lips: No new taxes” campaign promise, the top individual rate increased to 31 percent, and later spiked to 39.6 percent under President Clinton in 1993. The former C-corporations found themselves in a no better tax situation than before.
Just as easily, the 2017 Act and its 21 percent corporate tax rate could disappear under a future administration. In fact, on March 7, 2018, Senate Democrats released a blueprint of an infrastructure plan that calls for closing the carried interest loophole, increasing the corporate tax rate from 21 to 25 percent, returning to less generous estate tax exemptions, raising the top individual tax rate from 37 to 39.6 percent, and lowering the individual alternative minimum tax thresholds.
This plan is not likely to gain much traction with Congress's GOP majority, but with midterm elections coming up, that could very well change. Given the tax advantages of S-corporations and the uncertainty still surrounding many aspects of the new tax law, knee-jerk reactions and rash decisions should be avoided.
This article was originally published in the March 19, 2018 edition of NJBiz.
About Dawn Rhodes
Dawn Rhodes, CPA, is a Partner at Marks Paneth LLP. Bringing 20 years of public accounting experience to the position, Ms. Rhodes serves clients by providing a broad range of tax planning and consulting services for closely held businesses and individuals. Her areas of specialty include clients in the real estate industry, estates and trusts and high-net-worth individuals. She also focuses on partnerships, limited liability companies and corporations. Ms. Rhodes began her career at Leipziger & Breskin LLP, a... READ MORE +