We hosted a Facebook live event on Tax Reform Changes. You can watch the whole video here.
Here are my Top 3 Tax Reform Changes to save you money.
Tax Reform Change #1: Lower Individual Tax Rates
The Tax Cuts and Jobs Act is the biggest tax bill in 31 years and while it may look like 503 pages of nonsense to you, there really is reason behind all that rhyme.
The main focus is on cutting corporate tax rates. Not only for C-corporations but for the over 90% of America’s businesses that are pass-through entities. Also congress wanted to lower tax rates overall. They knew it would be politically tough to pass corporate reform without promising something to the people who work at those corporations.
Here’s the problem: cutting all those taxes costs money. So, Congress had to come up with what they all “pay-for” to make up for most of that lost revenue.
They did it in two ways:
First, they tightened or eliminated many of the deductions we’ve come to take for granted over the years: personal exemptions, state and local taxes, mortgage interest, and the like.
Second, and maybe more important, they phased out most of the personal changes, starting in 2026. Remember the ”fiscal cliff” we went over back in 2013? Don’t be surprised if we find ourselves facing another one in 2025!
Here’s what tax brackets looked like in 2017:
As you can see, there were seven brackets, starting at 10%, and rising to 39.6% on income over about a half a million dollars. Some people actually paid more than 39.6% if they owed self-employment tax or net investment income tax on top of regular income tax.
For 2018, the tax rates decreased, starting at 10%, and rising to 37% on income over $600,000. So, not only did tax rates decrease but taxable income thresholds also increased.
All the tax brackets are now paying a lower percentage of their income to taxes. This is good, but this will be offset by some deductions you will likely lose. So don’t spend the money yet.
Tax Reform Change #2: Lower Corporate Tax Rates
Under the new law, things get considerably easier. There’s a single flat rate of 21% that applies from your first dollar of income to your very last dollar of income. And there’s more good news! The new law eliminates the personal service company tax and corporate AMT. If you have a credit for prior years’ AMT, you can carry it forward to offset your regular tax liability.
The new rules will make C corporations far more valuable to business owners, and even investors.
Consider these examples:
Highly paid professionals who can incorporate their practice can take income in the form of salary, taxed at rates as high as 40.8% (37% for income tax plus 3.8% for Medicare tax). Alternatively, they can leave profits inside the corporation to be taxed at 21%, then take the after-tax net as a dividend, taxed at 23.8% (20% for income tax on qualified corporate dividends and 3.8% net investment income tax). Together, this will result in a 39.802 rate.
You can also use a C corporation as an alternative to a qualified retirement plan. Simply leave earnings in the corporation and withdraw them in a later year when you’re in a lower tax bracket.
If you’re nearing the end of your career, and don’t need the income for current living expenses, you can even leave them inside the corporation until your death. At that point, your heirs will enjoy a stepped-up basis on those assets, and can withdraw the accumulated funds tax-free.
Tax Reform Change #3: Qualified Business Income Deduction
Ok, now let’s talk about the most dramatic change in the new law. The Tax Cuts and Jobs Act focused most of its attention tinkering at the margin of existing concepts. The corporate tax rate is cut to a flat 21% -- but the basic framework remains the same. Standard deductions have essentially doubled – but the standard deduction concept remains the same. Personal rates are down across the board – but the basic graduated rate structure remains the same.
However, the law made one very important – and very unexpected – change. Specifically, it defined an entirely new kind of income from pass-through businesses.
The tax code has always recognized that there are different kinds of income – and treated those kinds of income differently.
Ordinary income is what you earn from your work or your business. And if you earn a salary from a job, and your spouse loses money in a business, you can net those amounts against each other. If you draw pension or IRA income, that’s ordinary income too. Ordinary income is taxed at ordinary rates.
Investment income is income you earn from your portfolio. And some of it, like taxable interest income, is also taxed at ordinary income rates. But different kinds of investment income can be taxed at different rates. Qualified corporate dividends, for example, are taxed at special rates and capped at 20%. Long-term capital gains from property held for more than a year are also capped at 20%. And investment income is subject to a 3.8% “net investment income tax” if your AGI exceeds $200,000 for single filers or $250,000 for joint filers.
Now, if you have capital losses in a year, you can subtract them from your capital gains. And you can subtract up to $3,000 of net capital losses against your ordinary income. But if your net capital loss is more than $3,000, you have to carry the remainder forward to future years. So, for the most part, investment income is walled off into its own little bucket.
By the mid-1980s, taxpayers had figured a way around those first two walls. They discovered they could use borrowed money to increase their basis in investments like real estate, oil & gas, and equipment leasing, and write off huge paper losses, well in excess of what they had actually invested.
They used those losses to offset their ordinary income from salaries and businesses, as well as investment income from their investment portfolios. That was great for taxpayers, of course, especially with marginal rates hitting 70%. But it wasn’t so good for the U.S. Treasury.
So, in 1986, Congress created a new category of income, called passive income, from activities where you don’t “materially participate.” The 1986 rules said that you can write off passive losses against passive income – but generally not against ordinary income or investment income. There’s a rental real estate loss allowance for up to $25,000 of rental property losses, but that phases out starting at $100,000 of adjusted gross income. And so-called “real estate professionals” who qualify under special rules can deduct passive real estate losses against ordinary income. But for the most part, the 1986 rules walled off passive income and losses into their own silo.
Now Congress has created a fourth kind of income: qualified business income
“Specified Service Business” Phaseouts
At least the phaseouts themselves are straightforward! They start at $157,500 for single filers, heads of households, and separate filers, and $315,000 for joint filers. The phaseout range is $50,000 for single filers, meaning the 20% deduction disappears entirely once taxable income reaches $207,500. And the range is $100,000 for joint filers, meaning the deduction disappears entirely at $415,000 for joint filers.
Now, don’t stop reading because you make over $415,000! You may be wondering doesn’t that exclude high income earners?
I work with a lot of physicians and they often ask, “doesn’t this new rule exclude all doctors?"
No, there is a limitation but not an exclusion if you are part of a high-income family and own a business in the service industry. If you are an independent contractor (paid 1099), in the eyes of the IRS you own a business. Physicians are one of the primary targets of this limitation on the service industry, but the average physician falls under it. The limitation is $315k of taxable income with a phaseout by $415k.
Service Business Workarounds
Now let’s talk about working around this “specified service business” limit.
The first opportunity, as we already discussed, involves defining the work you do to fall outside the definition of “specified service business.” These questions suggest the very first potential work-around involves how you classify your income to fly under the IRS radar. Something as simple as choosing the right six-digit business activity code number could make a huge difference here. The IRS is likely to “flag” certain business codes for extra scrutiny, and you’ll want to avoid those codes where possible. (Unfortunately, none of us in the industry can tell you now what they are!)
The second opportunity involves “craving out” a business into component parts to remove at least part of its income from the “qualified service business” category.
One of the most simple examples of a ”carving out” a medical practice is for dermatologists. The core functions of your professional practice – examining patients, prescribing medication, preforming procedures – all seem to fall pretty clearly under the umbrella of “health”. But dermatologists will normally have a retail side of their business as well. The sale of those products can be separated from their “professional services” and any profit from retail sales would qualify for the QBI deduction.
Another common scenario - Let’s say you’re a dentist, working to build up your practice and your income. The core functions of your professional practice – cleaning teeth, taking X-rays, and filling cavities – all seem to fall pretty clearly under the umbrella of “health.” But marketing your practice, billing your patients, chasing insurance companies for reimbursements, and managing staff, are general overhead functions that any business has to perform, whether they’re involved in a service activity or not.
So, why not set up a completely separate business – a “management company” – and establish contracts with your professional practice to provide those non-health related functions? At the end of the year, the net profit remaining in the professional practice will be subject to the “specified service business” limits just the same as it would have been without the management company. But the net profit from the management company should qualify for the QBI deduction.
Naturally, you’d have to dot your i’s and cross your t’s here. You’d have to establish and operate the new entity with the same formalities as any other business. You’d have to negotiate arms-length business contracts between the professional practice and the management company. You’d have to pay the management company a commercially reasonable fee for the services it performs for the professional practice, but not so much that you drain the professional practice of all its income.
Now, will all this really work? Will the IRS issue regulations holding that a business providing administrative support to a “specified service business” is lumped under that same umbrella? Will they hit you with the “step transaction” doctrine, disregard the management company entirely, and disallow the QBI deduction you’ve so carefully created? Honestly, who the hell knows right now?
If your business owns real estate, you’ll probably be on safe ground breaking out that real estate and paying the highest justifiable rent.
Finally, there’s a lot of talk about using “qualified agricultural co-ops” to get around the “specified service business” rules. Naturally, we’re keeping an eye out on that possibility!
Now that you understand how the new tax law works, let’s talk about where to go from here.
That’s where Gallati Professional Services comes in. We offer true, proactive tax planning to help you make the most of the new tax law, and catch up on opportunities you may have missed under the existing law, too.
We start by sitting down with you for a free Tax Analysis where we review your returns to find the mistakes and missed opportunities that may be costing you thousands in taxes you don’t have to pay.
We can’t tell you how much we can save until we sit down with you for the analysis. However, we can tell you that most business owners are wasting thousands of dollars a year in taxes they simply didn’t know they didn’t have to pay. You owe it to yourself to make sure you’re not one of them!
Contact us today to learn how these savings opportunities can be implemented for your tax situation.