Kurt Copeland, CPA

2017 Year-End Tax Planning for Individuals With Tax Reform In Mind

Individual income taxes, whether paid through employer withholding or quarterly estimates, are probably one of your largest annual expenditures. So, just as you would shop around for the best price for food, clothing, or merchandise, you want to consider opportunities to reduce or defer your annual tax obligation. This Tax Letter is intended to assist you in that effort.
Your 2017 year-end tax planning begins with a projection of your estimated income, deductions, and tax liability for 2017 and 2018. You should review actual amounts from 2016 to assist you with these projections. To the extent you can control the timing of income and deductions between 2017 and 2018, you should make decisions that will result in the lowest overall tax for both years. If shifting income and deductions between 2017 and 2018 does not reduce your overall tax liability, you should try to defer as much tax liability as possible from 2017 to 2018.
Tax planning for individuals also requires consideration of the tax consequences to any business conducted directly or indirectly by the individual owners. Accordingly, we suggest you also review our Tax Letter entitled Year-End Tax Planning for Businesses. In light of the legislative changes to the tax code that are pending as of the publication of the letter, there may be updates to the proposed tax reform discussed below.
This Tax Letter discusses planning for federal income taxes. However, state income taxes should also be considered. Your client service professional can be consulted regarding state tax matters.

Proposed Tax Reform (as of November 17, 2017)

House Proposed Bill
On November 16, 2017, the House approved their proposed tax bill, entitled “Tax Cuts and Jobs Act”. The bill proposes significant legislative changes to the current tax system which would change the current tax system for both individuals and businesses, beginning on January 1, 2018. Below are some of the major changes that should be considered when planning for 2018.
• Reduced Individual Tax Rates & Adjusted Brackets – The number of tax brackets is reduced from seven to four, with rates of 12%, 25%, 35%, and 39.6%.

• Alternative Minimum Tax – The bill would eliminate the Alternative Minimum Tax (AMT) beginning in 2018. It allows taxpayers to carry forward any AMT credits they have, and claim 50% of the remaining credits (to extent the credits exceed regular tax for the taxable year) in tax years 2019, 2020, and 2021. Taxpayers would be able to claim 100% of the remaining credit in 2022.
• Standard Deduction – The bill establishes a new standard deduction of $24,400 for married taxpayers filing jointly, $18,300 for unmarried taxpayers with at least one qualifying child, and $12,200 for other filers, while eliminating the personal exemption. The additional standard deduction for the elderly and the blind would be repealed.
• Itemized Deductions – The bill proposes to repeal the itemized deduction phaseout, the deduction for state and local income taxes paid, the deduction for tax preparation expenses, the deduction for medical expenses, and the deduction for unreimbursed employee expenses. The House proposal retains the deduction for property taxes, but caps the deduction at $10,000 per year. The mortgage interest deduction is retained, but would be limited to interest paid on acquisition indebtedness of up to $500,000 (mortgages existing prior to November 2nd will be grandfathered under the current law). The bill also proposes to keep the charitable contributions deduction, but would increase the adjusted gross income limitation for cash gifts to public charities to 60% of adjusted gross income (up from 50% under the current law).
• Gain on Sale of Principal Residence – The House bill would retain the $500,000 exclusion for the gain on the sale of a principal residence, but amends the use and ownership test to require that the taxpayer reside in the residence for 5 out of previous 8 years. However, the benefit of the exclusion would phase out if the taxpayer’s average modified adjusted gross income over the current and previous two years exceeds $500,000 for joint filers ($250,000 for single). Taxpayers would only be entitled to this exclusion every 5 years.
• Small Businesses & Partnerships – The House bill proposes to tax a portion of the qualified business income of sole proprietorships, partnerships and S corporations at a rate of 25%. Generally, under a safe harbor provision, owners would be able to treat 30% of the net business income derived from active business activities as subject to the 25% rate. The remaining net business income would be taxed at the ordinary income rates. In lieu of the safe harbor, taxpayers would be able to elect to apply a facts and circumstances test based on the rate of return of capital investment over the net business income for that activity. Such election is a five-year irrevocable election. Personal service businesses (such as law, accounting, consulting, engineering, financial services, or performing arts), are not eligible to claim this preferential rate; however, they may be able to elect to use the facts and circumstances test if they make significant capital investments.
• Elimination of Estate and Generation-Skipping Transfer Tax – The bill would double the current lifetime estate and gift exemption starting in 2018. Beginning in 2025, the estate and generation-skipping transfer taxes would be repealed. Even after the repeal of the estate tax, however, taxpayers would continue to receive a step-up in the basis of the assets inherited at death. The gift tax would remain after the repeal of the estate tax, but the lifetime exemption would be reduced to $10,000,000 (indexed for inflation) and the maximum marginal gift tax rate would be lowered to 35% (currently 40%).
• Miscellaneous Provisions:
o Private activity bond interest income would no longer be excluded from gross income for bonds issued after 2017. Private activity bond interest income would be subject to ordinary income tax rates.
o Alimony payments would no longer be an above-the-line deduction for the payor and would includible in income for the payee. Existing alimony and separate maintenance agreements would be grandfathered under the current law.
o Education credits would be consolidated into a single credit called the American Opportunity Tax Credit. The credit would equal 100% of the first $2,000 of qualified tuition and related expenses plus 25% of the next $2,000 of qualified tuition and related expenses. Up to $800 of the credit would be refundable.
o The above-the-line deductions for student loan interest and qualified tuition and related expenses would be repealed.

Senate Proposed Bill

On November 16, 2017, the Senate Finance Committee approved their version of the "Tax Cuts and Jobs Act", sending the bill to the full Senate for a vote. Below are some of the legislative changes proposed. The Senate proposal calls for the expiration of their proposed changes effecting individuals on December 31, 2025.

• Individual Tax Rates & Adjusted Brackets – The number of tax brackets remains at seven, but there are new rates of 10%, 12%, 22%, 24%, 32%, 35%, and 38.5%. Under the Senate proposal, these rates would expire after December 31, 2025.

• Standard Deduction – The Senate proposal would establish a new standard deduction of $24,000 for married taxpayers filing jointly, $18,000 for head-of-household filers, and $12,000 for other filers, while eliminating the personal exemptions. The additional standard deduction for the elderly and the blind would be retained.
• Small Business and Partnerships – The Senate proposes to allow an individual taxpayer to deduct 17.4% of the “domestic qualified business income” from a partnership, S corporation, or sole proprietorship. Domestic qualified business income is defined as income, gain, deduction and loss with respect to a taxpayer’s qualified business. It does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer or any amount distributed or allocated to a partner who is acting other than in his capacity as a partner for services or certain investment related income, gain, deductions or loss. The deduction would be limited to 50% of the W-2 wages for taxpayers who have qualified business income from partnerships or S corporations. The deduction does not apply to health, law, engineering, architecture, 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 or skill of one or more of its employees.

• Itemized Deductions – The Senate proposes to eliminate the home equity interest deduction, but retains the current interest deduction on acquisition indebtedness. The Senate proposal would also eliminate all state and local tax deductions (income and real property), unless incurred in carrying on a trade or business. The proposal would also repeal all miscellaneous itemized deductions that are subject to the two-percent floor and the overall itemized deduction phaseout. The Senate also proposes to keep the charitable contributions deduction, but would increase the adjusted gross income limitation for cash gifts to public charities to 60% of adjusted gross income (up from 50% under the current law).

• Gain on Sale of Principal Residence – The Senate proposal retains the $500,000 exclusion for the gain on the sale of a principal residence, but amends the use and ownership test to require that the taxpayer reside in the residence for 5 out of previous 8 years. Taxpayers that fail to meet the use and ownership test by reason of change of place of employment, health, or unforeseen circumstances, would be entitled to a pro-rated exclusion based on the fraction of the five years that the use and ownership requirements are met. Taxpayers would only be entitled to this exclusion every 5 years.

• Basis of Stock Sold - The Senate proposal would eliminate the ability to specifically identify the stock lot sold and would generally require taxpayers to use a first-in, first-out cost basis for any stock disposed of after January 1, 2018.

• Estate and Generation-Skipping Transfer Tax – The Senate proposal does not repeal the estate, gift, or generation-skipping transfer taxes. Nevertheless, the proposal doubles the lifetime estate and gift exemption beginning in 2018.

• Alternative Minimum Tax – The Senate proposal would eliminate the Alternative Minimum Tax (AMT) beginning in 2018. It allows taxpayers to carry forward any AMT credits they have, and claim 50% of the excess of the credit available over the credit allowable in 2018, 2019, and 2020. Taxpayers would be able to claim 100% of the remaining credit in 2021.

In light of reform, you might want to consider:

• Accelerating the payment of your fourth quarter state income taxes into 2017 (as long as it does not result in you being subject to the AMT), as this may be eliminated from itemized deductions starting in 2018.
• Accelerating the payment of other itemized deductions, such as medical expenses, real estate taxes, personal property taxes, investment interest expense, tax preparation fees and other miscellaneous deductions into 2017.
• Deferring ordinary income expected to be taxed at the highest marginal rates into 2018, as the aforementioned plans propose to reduce the income tax rates in 2018.
• Consider gifting low basis stock to charity or harvesting stock losses before year end if you have multiple lots of the same stock.
• Waiting on making taxable gifts that would result in gift tax due.

2017 Versus 2018 Marginal Tax Rates

Whether you should defer or accelerate income and deductions between 2017 and 2018 depends to a great extent on your projected marginal (highest) tax rate for each year. With the proposed compression of the income tax rates starting in 2018, you should analyze of your anticipated marginal tax rates for 2017 and 2018.
The highest marginal tax rate for 2017 is 39.6% but the highest marginal tax rate for 2018 may lower. While the income tax rates in 2018 are proposed to be lower, the elimination of many itemized deductions may result in higher marginal rates in 2018 for some taxpayers. Also, it is still unknown what will happen to the additional 3.8% tax on the net-investment income of high-income taxpayers. The tax rates for 2017 and 2018 (under current legislation, without consideration for proposed tax reform) are included in this Tax Letter (see page 31). Projections of your 2017 and 2018 income and deductions are necessary to estimate your marginal tax rate for each year.

Shifting Income and Deductions Into the Most Advantageous Year

You can shift taxable income between 2017 and 2018 by controlling the receipt of income and the payment of deductions. Generally, income should be received in the year with the lower marginal tax rate, while deductible expenses should be paid in the year with the higher marginal rate. If your top tax rate is the same in 2017 and 2018, deferring income into 2018 and accelerating deductions into 2017 will generally produce a tax deferral of up to one year. On the other hand, if you expect your tax rate to be higher in 2018, you may want to accelerate income into 2017 and defer deductions to 2018. Keep in mind, however, that the aforementioned proposed tax reform anticipates the repeal of most itemized deductions.
Planning Suggestion: The time value of money should be considered when making a decision to defer income or accelerate deductions. Comparative computations should be made to determine and evaluate the net after-tax result of these financial actions.

Moreover, you should consider whether you expect to be subject to the alternative minimum tax (“AMT”) for either or both years (see page 25). It is important to note, as mentioned earlier, that the tax reform proposal is contemplating the repeal of the AMT.
Controlling Income
Income can be accelerated into 2017, or deferred to 2018, by controlling the receipt of various types of income depending on your situation, such as:
For Business Owners
• Year-end interest or dividend payments from closely-held corporations;
• Rents and fees for services (delay December billings to defer income); and
• Commissions (close sales in January to defer income).
Caution: Income cannot be deferred to 2018 if you constructively receive it in 2017. Constructive receipt occurs when you have the right to receive payment or have received a check for payment even though it has not been deposited. Income also cannot be deferred if you effectively receive the benefit of the income; for example, if you are allowed to pledge a deferred compensation account balance to obtain a loan.
Bonuses for work performed in a particular year can be deferred to the next year if an election is made no later than the end of the year proceeding the year the work is to be performed. Accordingly, bonuses for work to be performed in 2017 can be deferred to 2018 if the required election was made before the end of 2016.

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