US Tax Reform – implications for individuals
9 October 2018
The changes introduced by the tax reform act apply from 1 January 2018 unless otherwise stated below. In addition, the following provisions will expire after 31 December 2025 unless otherwise extended by the US government:-
- lower individual tax rates;
- higher alternative minimum tax (AMT) exemption amounts;
- the elimination and modification of many individual deductions, and the increased estate and generation skipping tax exemption.
Estate and gift tax
The estate and gift tax exemption is doubled to $11.18 million. This will increase to $11.4 million for 2019. The generation skipping transfer tax exemption is also increased to $11.18 million.
For 2026 and beyond, the exemption will revert $5 million, as then adjusted for inflation. This led to some concerns of a possible clawback in the event that individuals gifted more than $5 million during their lifetimes and subsequently died after 2015. Newly proposed regulations indicate that there is unlikely to be any such clawback.
US individuals should now contemplate making gifts to family members and dynasty trusts in order to take advantage of the increased exemptions.
Individual Tax Rates
The TCJA reduced the marginal individual tax rate from 39.6% to 37%. The rate for long term capital gains and qualified dividends remains unchanged at 20%.
Individuals running a business through a partnership or other pass-through entity may benefit from a 20% deduction on passthrough income as explained below. However such individuals may be better off converting to C corporation status in order to take advantage of the reduction in corporate tax rates from 35% to 21%.
The standard deduction is doubled to $24,000 for married couples filing jointly ($12,000 for single filers).
Miscellaneous itemised deductions subject to the “2% floor” have been repealed, including expenses incurred by employees. Note that “above the line” deductions from gross income are not “itemised deductions”, and are therefore not affected by the disallowance of miscellaneous itemised deductions. These include for example trade or business expenses, capital losses, and some deductions attributable to rental property and royalties.
The overall limitation on itemised deductions is repealed. The limitation, commonly referred to as the “pease” limitation, reduced a taxpayers itemised deductions by 3% for every dollar over a threshold amount.
The medical expense deduction “floor” is reduced from 10% to 7.5% of adjusted gross income (“AGI”) and the AMT tax preference is eliminated. The floor operates by only allowing a deduction for medical expenses to the extent they exceed 7.5% of AGI.
There is now a $10,000 limit on state and local income, sales, and real estate taxes claimed as an itemised deduction. Note that state and local taxes are still deductible in above the line situations, such as the computation of income from rental property.
The itemised deduction for cash charitable gifts to public charities has increased from 50% to 60% of adjusted gross income. The limit for donations to private non-operating foundations generally remains at 30%.
Note that the disallowance of deductions may have an impact on state income taxes because some states base their income tax on federal taxable income.
In terms of deduction planning, individuals may wish to consider “bunching” deductions such as charitable donations into a single year (rather than over several years), and relying on the standard deduction in the intervening years.
The personal and dependency exemptions have been completely repealed. This provision is largely irrelevant to higher income individuals, since personal exemptions were phased out under prior law beginning at incomes above $320,000
Alimony was previously deductible for the payor and treated as income for the recipient. This rule has been reversed so that there is now no deduction for the payor and no income for the recipient. This provision applies to divorce decrees, separation agreements, and certain modifications entered into after 2018.
The tax change may cause problems for divorces settled after 31 December 2018 because one spouse will lose a tax benefit and the other will gain one. It is already the case that child support and property settlements do not produce a deduction, and after December neither will alimony.
The deduction for moving expenses is suspended, except for active duty members of the Armed Forces who move pursuant to a military order and incident to a permanent change of station. The deduction previously applied to moving expenses incurred in connection with starting a new job at least 50 miles further away from the individual’s former residence.
Previously a deduction was allowed for personal casualty losses in certain circumstances. The deduction for personal casualty losses is now limited to situations where there has been a federally declared disaster.
Net operating losses can be carried forward indefinitely (no longer limited to 10 years), cannot be carried back, and are limited to 80 percent of future taxable income. This rule applies to losses incurred from 1 January 2018. Losses carried forward from previous years are grandfathered i.e. the 80% limitation does not apply.
Where an individual has net excess business losses, they may previously have been eligible to offset the entire amount against other income, such as salary or investment income. From 1 January 2018, the deduction is restricted to $500,000 of business losses ($250,000 for single filers), with any excess being suspended and carried over to the following year as a net operating loss (“NOL”) carry forward.
An income tax deduction is allowed of up to 20% of “qualified business income” (“QBI”) from passthrough entities (such as partnerships) for business owners with income under $157,500 ($315,000 for married filing jointly), to compensate for the drop in corporate tax rates from 35% to 21% rate and prevent non-corporate businesses from having to incorporate
The passthrough deduction applies only with respect to income effectively connected with the conduct of a US trade or business. Real estate income will qualify provided the activity meets the definition of trade or business.
Individuals with taxable income over $157,500 ($315,000 for married filing jointly) are subject to the following limitations:-
- The deduction does not generally apply to individuals with pass-through income from “specified service businesses” in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services.
- The deduction is limited to the greater of (a) 50% of the W-2 wages paid with respect to the qualified trade or business, and (b) the sum of 25% of the W2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis of all “qualified property”. Qualified property is tangible property subject to depreciation, held by a qualified trade or business, and used in the production of QBI.
Sale of partnership by non-residents
Non-resident individuals selling an interest in partnership engaged in the US trade or business may previously have been able to escape paying US tax on a sale of the partnership interest.
With effect from 27 November 2017, any gain or loss realised from the sale exchange of an interest in such a partnership is now taxable, to the extent that the sale of the partnership assets would have produced effectively connected gain or loss.
Furthermore, the transferee of the partnership interest is required to withhold 10% of the gross proceeds realised, unless the transfer or provide certification that it is a US resident taxpayer.
These rules give rise to considerable uncertainty in terms of calculating the taxable amounts, and hence difficulty for the person responsible for the withholding. In recognition of these difficulties, the IRS announced that the application of the withholding rules would be suspended until regulations or other guidance has been issued.
Carried interest held by fund managers
Fund managers are often remunerated partly with “carried interest” which is an indirect interest in the underlying investments of funds under management, effectively enabling the individual to benefit from long term capital gains rates.
The act introduces a three-year holding period in order for carried interest to qualify for long term capital gains rates.
The new rule works by re-characterising gains from an “applicable partnership interest” from long-term capital gains into short-term capital gains to the extent that the gains relate to property with a holding period of not greater than three years. An “applicable partnership interest” is a partnership interest held in connection with the performance of “substantial services” by the taxpayer in an “applicable trade or business”. An “applicable trade or business” is the activity of raising or returning capital, as well as investing in securities, commodities, real estate, or partnership interests.
Furthermore if an individual transfers carried interest to a related person, then they will recognise a short-term capital gain on any assets held for three years or less.
Controlled foreign corporations (“CFCs”)
The circumstances in which a foreign corporation will be treated as a CFC are expanded as follows:-
- Under previous law, a US shareholder was defined as any US person owning 10% of the voting stock in a foreign corporation. This definition is now expanded to include any US person with 10% of the value of the stock.
- Under previous law, a US shareholder of a foreign corporation was required to include subpart F income for a year only if it had been a CFC for at least 30 consecutive days for such year. The 30-day requirement is eliminated.
- Stock in a foreign corporation is now attributed “downward” from a foreign person to a related US person for the purposes of determining whether the US person is a US shareholder of the foreign corporation and therefore whether the foreign corporation is a CFC. This provision is intended to render ineffective transactions in which a foreign parent would acquire a larger than 50% interest in a CFC of its US subsidiary and therefore prevented the foreign corporation from being a CFC.
The act imposes a one-off tax charge on US shareholders of CFCs, a CFC being a foreign corporation that is more than 50% owned by 10% “US shareholders”. The US shareholder is taxed in 2017 on a deemed repatriation of all of the previously untaxed foreign earnings and profits since 1986.
The repatriation tax applies to both individual and corporate shareholders.
The tax rate depends on whether the earnings are attributable to cash. Amounts attributable to cash and cash equivalents are taxed at an effective rate of up to 17.5%, and all other amounts are taxed at up to 9.1%.
Various bodies have submitted representations to the Treasury on the harshness of the transition tax and GILTI (explained below) as it concerns individuals, and the Treasury has indicated that guidance on the application of the tax to individuals will be forthcoming.
A US shareholder in a controlled foreign corporation is required to include in taxable income, as a deemed dividend, their share of the corporations “global intangible low taxed income” (“GILTI”). The tax is designed to prevent tax avoidance by US multinational companies by shifting profits to their foreign subsidiaries. However the GILTI tax applies equally to individuals, including both individuals with non-US operating businesses structured as corporations, and interests in investment funds which hold foreign portfolio companies meeting the definition of a CFC.
GILTI is calculated as the excess of the CFC’s income (not already subject to US tax) over a net deemed tangible income return. The net tangible income return is broadly 10% of tangible depreciate property used in the trade or business.
Corporate shareholders are eligible for a 50% deduction resulting in an effective US tax rate of 10.5% (i.e. 50% of the new 21% corporate rate). Furthermore a corporation may offset the US liability with a foreign tax credit equal to 80% of foreign taxes paid by the CFC. Therefore US corporate shareholders may escape the GILTI altogether, depending on the level of foreign taxes being paid.
US individual shareholders are neither eligible for the 50% GILTI deduction nor the ability to claim foreign tax credits. GILTI is taxable at standard rates of up to 37%. Individuals who are affected may be able to reduce the impact of the GILTI tax by electing to be taxed as if they were a domestic corporation, in order to benefit from the same reduced rate of tax on GILTI that is available to a domestic corporate shareholder i.e. 10.5% instead of 21%. It is not yet clear whether this course of action is effective, and the Treasury has been asked by various commentators to provide clarification.
Separate foreign tax credit basket for foreign branches
Under existing US rules, foreign taxes paid on one source of income can be offset against the US tax on another item of income of a similar type. Foreign taxes are grouped together in “baskets”, the main categories being “general limitation” (which includes “earned” income) and “passive”. Foreign taxes in a given category can only be used to offset the US tax on other income in that particular category. This generally prevents foreign tax on “earned” income being used to offset the US tax on “passive” income. To the extent that there are surplus available foreign taxes in a particular basket, these excess credits are carried back one year and then forward 10 years to be offset against the first available US taxes on foreign income in the same basket.
Tax reform introduces a new “foreign branch” category of income and foreign tax credits, which is defined as the business profits attributable to one or more qualified business units in foreign countries, and excludes any income which would otherwise be treated as passive basket income.
The immediate impact obvious change is that taxpayers are likely to have excess credits from previous years effectively “stranded” in the general limitation basket. Under previous rules, these credits would have been off-settable against the US tax on future business profits. The creation of the new foreign branch basket effectively means that these credits may be lost altogether.
Although corporate AMT has been repealed, the individual AMT is still applicable. The AMT exemption is increased to $109,400 for joint filers ($70,300 for all other taxpayers except estates and trusts). The phase-out thresholds were increased to $1 million for joint filers and $500,000 for all other individuals.
Under previous law, no gain or loss was recognised if property used in a trade or business or for investment was exchanged for “like kind” property that is held for use in a trade or business or for investment.
Tax-free like-kind exchange treatment now applies only to real estate.
Electing Small Business Trust (ESBT) changes
An Electing Small Business Trust is a trust that can hold the stock of a Subchapter S corporation. ESBTs are often used to plan for estate planning purposes, for example to transfer the corporate stock to the donor’s heirs after their death.
The act permits, for the first time, non-resident aliens to be potential current beneficiaries of an ESBT.
Qualified equity grants
The act provides tax benefits to employees of some start-up companies. An employee may make an election with respect to qualified stock received, so that no amount is included in income for the year of receipt. The employee can defer tax until the earlier of (a) five years, or (b) the occurrence of a specified event, such as the stock of the company being readily tradable revoking of the election. At least 80% of the employees of the company must be granted stock options or restricted stock units (RSUs) with the same rights and privileges.
Deduction for business interest
The deduction for business interest is limited to the total of the amount of business interest plus 30% of adjusted taxable income. This restriction only applies to individuals who have more than $25 million in average gross receipts, and therefore is unlikely to affect many individual individuals.
Individuals who average less than $25 million in gross receipts for the past three tax years may now use the cash method of accounting for tax purposes.
Entertainment and other expenses
Before 2018, businesses could claim a deduction of 50% of business meal and entertainment expenses, but only to the extent they were directly related or associated to the active conduct of the trade or business. This deduction has been repealed.
UK digital services tax. The UK government is consulting on the introduction of a 2% turnover tax on digital multinationals deriving value from the UK.