By John Peace and Cal McCastlain
The Tax Cuts and Jobs Act, signed into law on December 22, 2017, impacts everyone. All business owners should analyze how the new law impacts their cash flow and growth strategies. And everyone . . . everyone, should review their estate plans for opportunities to simplify their estate plans and focus on their current estate planning needs.
Introduction. While the new tax law has extensive and complicated income tax planning opportunities, the estate tax planning provisions are simple by comparison. Simply put, the estate tax exemption is increased to $11.2 million for each individual ($22.4 million for a married couple). That means the estate plan for most people can be much simpler. To be clear, we strongly recommend that everyone at least have a Will. But the significant relief from estate taxes should not cause complacency as to other serious estate planning subjects. For example, there are still valid reasons to have a revocable living trust to avoid the cost and complexity of probate. An estate plan is about more than estate taxes. Your estate plan should address how you want your assets managed, by whom, and, ultimately, who receives benefits. The larger your estate, the more significant these issues.
Asset Management. Asset management is not only about the ultimate disposition of your assets.
It also involves management during your lifetime. If managing your assets is a challenge for you, or if you have simply reached the point where you no longer wish to manage them, you should consider how you want your assets to be managed, and by whom. Possible management situations range from appointing a power of attorney to establishing a trust with successor trustees identified. Which situation is best depends on each person and situation.
Transfer of Assets During Lifetime. Even if estate taxes are not a concern, there may be good reasons and opportunities to consider transferring assets to beneficiaries during your lifetime. Those transfers can be gifts outright to the beneficiary, or transfers in trust. Other options include sales with seller financing and transfers that are part gift-part sale.
Transfer of Assets After Death. You may provide for the ultimate disposition of your assets through a Will or a Trust. As stated earlier, we recommend that everyone have a Will. Whether and to what extent you may use a trust depends on your situation. While a Will must be probated, there are many ways to minimize probate, or effectively eliminate it. These methods include lifetime transfers to a trust for your benefit (revocable or irrevocable), ownership of property as joint tenants with right of survivorship, and accounts with pay-on-death beneficiaries.
Beneficiaries’ Situations. Careful consideration should be given to each beneficiary’s known and expected situations. Beneficiaries are not all the same, and the differences of each beneficiary should be taken into account. Consider each beneficiary’s age at the expected time they are to receive a gift or bequest, their financial maturity, their legal and marital exposures and any issues particular to the beneficiary. Trusts are good mechanisms through which these issues can be addressed, and at the same time “equalize” the amount of transfers among a class of beneficiaries.
Benefitting Multiple Generations. If you want assets managed for the benefit of multiple generations, a trust quickly comes to mind. The terms and conditions of a multi-generation trust can be as varied as the individuals establishing them. All such trusts must start with a timely discussion about the grantor’s goals and intentions.
Flexibility/Revocability. Because the estate tax exemption is now $11.2 million for each individual ($22.4 million for a married couple), most estate plans will be able to accomplish their goals through Wills and Revocable Trusts. The ability to amend or revoke the Will or Revocable Trust enables everyone to make a comprehensive estate plan under known circumstances, and then amend the documents as desired to reflect a change of mind or life changes such as death, divorce, disability or legal risks.
Existing Irrevocable Trusts. Continue to carefully manage any existing irrevocable trusts. Existing irrevocable trusts were likely set up to achieve estate tax savings. Even with the higher estate tax exemptions, those existing irrevocable trusts may still serve a purpose and, in most cases, hold valuable assets such as life insurance policies or appreciated capital assets. These existing irrevocable trusts should be reviewed for their purpose and assets and taken into account for the overall estate plan. If appropriate, the Arkansas Trust Code now allows irrevocable trusts to be modified or even terminated if the grantors and beneficiaries all agree.
Estate & Gift Taxes. Unless renewed by Congress, the new estate & gift tax exemption ($11.2 million per person) expires in 2026 and reverts back to the 2017 level of $5.4 million per person. Persons in the taxable estate range should consider taking advantage of the new higher estate & gift tax exemption in the event the new higher exemption is not extended. Remember the year-end rush of gifting in 2012. The 2026 expiration gives us more planning time to use the higher estate & gift tax exemption, and we expect there will be some IRS guidance in this area. In any event, your gifting strategies should account for the possibility of the $11.2 million estate & gift tax exemption expiring in 2026.
Step Up in Basis. The new tax law retains the step-up in tax basis of assets, so a decedent’s assets get a date of death market value basis.
Medical Issues/Living Will. It is very common during estate planning discussions to discuss a Medical Power of Attorney or Living Will, which is intended to give instructions to attending physicians regarding end of life treatment.
Update Your Estate Plan. Use the significant changes to the tax laws as an impetus to complete or update your estate plan.
Introduction. There are significant changes to business taxes, many of which apply to specific industries. The discussion below addresses provisions that have broad business applications.
Corporate Tax Rates. C corporations are now taxed at a flat rate of 21%, while individuals remain subject to a range of marginal tax rates up to 37%. The new tax law limits this tax rate disparity to some extent by allowing pass-through entities a 20% deduction on “qualified business income.” Still, this disparity in tax rates presents the need to compare operating a business as a C corporation or as a pass-through entity, such as an S corporation or LLC.
With use of the term “qualified business income”, you can expect limits and complications to this 20% deduction. For purposes of this summary discussion, the following points illustrate the need for a careful analysis of the disparity in the flat tax rate for C corporations and the marginal tax rates of individuals operating pass-through entities:
- The 21% flat tax rate of a C corporation will cause corporations previously in the lower tax brackets, e.g. 15%, to now be in a higher tax bracket. This rate increase is of particular concern for the company that is reinvesting its profits in the company or for related entities that do not file consolidated returns.
- Pass-through entities should analyze whether it is advantageous to convert their tax status to a C corporation to stay in the fixed 21% rate, or make other business structural changes among related entities.
- The 20% deduction for pass-through entities is calculated from the entity’s qualified business income. The full deduction is available to owners with taxable net income not exceeding $157,500 (or not over $315,000 for a married couple filing jointly).
- For those taxpayers exceeding these net income limits, their portion of the qualified business income eligible for the 20% deduction is limited to the greater of 50% of the W-2 wages paid by the business or the sum of 25% of W-2 wages paid plus 2.5% of the cost basis of the business’s tangible assets subject to depreciation.
- The 20% deduction for pass-through entities providing services, such as legal, accounting and consulting services, among others, is phased out for taxable income between $157,500 and $207,500 (between $315,000 and $415,000 for married filing jointly). Service entities do not qualify for the exceptions listed in paragraph 4.
- Also, “reasonable compensation” paid to the owners and guaranteed payments to partners do not qualify for the 20% deduction.
- The terms “qualified business income” and “reasonable compensation” are not firmly established. Consequently, each business situation (current and planned) must be reviewed carefully before making any decisions to change the tax status of a C corporation or a pass-through entity.
In short, choice of being taxed as a C corporation or a pass-through entity is significant for tax purposes. Review your entity tax status and income projections to determine whether and how the new business tax rates impact your company.
Depreciation. The IRC Section 179 election for expensing equipment in the year of purchase is increased from $500,000 to $1 million. This new $1 million limit is reduced dollar-for-dollar to the extent the equipment purchased during the year exceeds $2.5 million. The definition of Section 179 property includes certain components of nonresidential real property, including roofs, HVAC equipment, fire protection and alarm and security systems.
Additionally, the new law increases the bonus depreciation in the year of purchase from 50% to 100% of the cost of the purchase. This new bonus depreciation applies to new and used equipment. The ability to apply the bonus depreciation to used equipment is significant for (i) analyzing the company’s net cost benefit between a new and used piece of equipment; and (ii) in reviewing the purchase of any operating business.
Farmers purchasing new 7-year equipment after 2017 can depreciate that equipment over 5 years using 200% declining balance, unless they elect out of the business interest expense limitation discussed below.
Net Operating Losses. These new depreciation expensing limits should be taken into account in projecting taxable income (i) for the choice of entity tax rate analysis discussed above and (ii) to plan for any NOL, because new rules apply to NOLs. Except for some farm and insurance businesses, the new law does not allow NOLs to be carried back to prior years. Now NOLs can be carried forward indefinitely, but they are limited to 80% of the taxable income for the year to which the NOL is carried. Farmers may elect a 2-year carryback, or carry the loss forward indefinitely.
Excess Business Loss and Excess Farm Loss. For taxpayers other than C corporations, the amount of NOL deduction is further limited to amounts that do not exceed the “excess business loss” and “excess farm loss” under IRC Section 461. These excess loss amounts are annual losses in excess of $250,000 for an individual and $500,000 for married couples filing jointly. Loss amounts in excess of these limits cannot be deducted in a single tax year and must be carried forward, in which case they will be treated like NOL carryforwards.
Business Interest Expense. The deduction for business interest expense is now limited to 30% of the business’s adjusted taxable income, with some specific adjustments. This limit does not apply to businesses with average annual gross receipts that do not exceed $25 million, calculated over the three previous tax years. Certain real estate and farming businesses may elect out of this limit, but the election requires use of the alternative depreciation system (ADS).
Like-Kind Exchanges. Section 1031 like-kind exchanges are now limited to real estate. So, livestock and other farm equipment are no longer eligible for the 1031 like-kind exchange tax deferral. Minerals and timber that have not been severed are considered real property and are still eligible for Section 1031 transactions.
Cash Accounting. Family farm corporations with annual gross receipts not exceeding $25 million have been able to and can still use the cash method of accounting. Under the new tax law the cash method of accounting is now available to C corporations, and partnerships with C corporation partners, with annual gross receipts not exceeding $25 million, determined by a 3-year average receipts test applied annually.
Time to Act. The new tax law is certainly not simple, and some of the provisions start expiring in 2022. But for now, the new tax law provides significant income tax planning opportunities. We recommend that you start reviewing tax planning opportunities right away.
This article was published in the Arkansas Society of Certified Public Accountants' April 2018 newsletter.