In the eyes of many individual taxpayers who toil hard to pay significant tax bills, the Tax Cuts & Jobs Act (H.R.- 1 bill) released by the House Ways & Means Committee this week doles out too many tax cuts to big business, and not enough to small business and individuals.
The advertised 25% tax rate on small business pass-through entities (PTE) turned out to be deceptive and a dud. The media should stop calling it a 25% rate it’s more like 32%, or even higher. (See my blog post, Why The House Tax Cut May Disappoint Owners Of Pass-Through Entities.)
“This bill leaves too many small businesses behind,” said National Federation of Independent Business CEO Juanita Duggan in a statement. “We are concerned that the pass-through provision does not help most small businesses.”
In the spirit of tax reform and simplification, the bill repeals essential deductions for individuals including itemized deductions for state and local income, sales and personal property taxes, medical expenses, casualty losses, unreimbursed employee business expenses, and tax compliance fees. The bill repeals AGI deductions for alimony, moving expenses, student loan interest, and tuition expenses. The bill also repeals a business deduction for entertainment expenses. To curry last-minute support from members of Congress in high-tax states, the House agreed to an itemized deduction for real property taxes up to $10,000 per year.
The bill would take effect in years after Dec. 31, 2017, except for a few provisions like increased expensing and the change in mortgage deduction.
The investment management industry and investors come out with flying colors, probably thanks to tax writers being cozy with Wall Street banks, and billionaires operating hedge funds and private equity firms.
Sneakily, the bill retains carried interest tax breaks for hedge funds and private equity firms. Most people recall how President Trump pledged many times on the campaign trail to repeal the carried interest loophole, which occurs when an investment manager receives a portion of investors’ long-term capital gains (taxed up to 20%) rather than incentive fees subject to ordinary tax rates and Social Security and Medicare taxes. (I am not opposed to carried interest; it’s long-standing partnership tax law for owners with sweat equity.) (Postscript Nov. 6: Ways & Means changed the carried interest provision in the tax bill to require a three year holding period for long-term capital gains earned by managers.)
Without any explanation, the bill also quietly retains itemized deductions for investment interest expenses and investment expenses. Earlier tax reform blueprints repealed all itemized deductions, except mortgage interest and charitable contributions. Someone slipped this back in. Under current law, investment expenses are deductible as a “miscellaneous itemized deduction” if they are more than 2% of AGI. Miscellaneous itemized deductions are not allowed for AMT. The bill repeals AMT, which has the effect of expanding the investment expense deduction for upper-income taxpayers, many of whom have significant investment portfolios.
Investment interest expense is limited to investment income. I was concerned that repealing these tax breaks for investors and investment managers might upset financial markets and the investment management industry. Many in the investment industry must be cheering!
Traders face the same tax compliance challenges in 2018
The tax simplification measures don’t affect traders eligible for trader tax status (TTS). Investors and TTS traders should expect to receive complicated 1099-Bs from securities brokers in 2018, have wash-sale loss adjustments on securities, and deal with different tax treatment on various financial products including securities, futures, forex, options, ETFs, ETNs, cryptocurrencies, and more. I cannot think of any TTS trader that will file a tax return on a “postcard.”
In 2018, TTS traders can continue to deduct tax compliance fees as a business expense, whereas individuals without a business lose that itemized deduction. TTS traders can probably have a business expense for a portion of state and local taxes related to business income.
The proposal covers a multitude of tax law changes, but I focus on changes that affect our clients the most. Here’s the breakdown.
The bill doesn’t change:
• Capital gains and losses
The bill does not affect capital gains and losses. The tax code retains long-term capital gains rates (up to 20%), including on qualified dividends and the 60% long-term capital gains portion of Section 1256 “60/40″ capital gains rates.
The bill does not change Section 1091 wash sale loss adjustments, Section 475 MTM ordinary gain or loss treatment for TTS traders, and Section 988 forex ordinary loss treatment and the forex capital gains election. The bill does not affect the rules for TTS traders having business expense treatment but investment income (not business income). The press release mentions including interest income in the lower long-term capital gains rate.
• High-deductible retirement plans
Tax writers backed off an earlier threat to reduce 401(k) tax-deductible contributions from $18,500 for 2018 to a significantly lower amount.
• Health insurance premium deduction
The bill also leaves health insurance premium deductions alone, including Health Savings Accounts and Health Reimbursement Accounts.
• Obamacare net investment tax
The bill doesn’t repeal the Obamacare 3.8% net investment tax (NIT). State and local taxes should still be deductible for NIT even if repealed as an itemized deduction.
The bill changes:
• Increased expensing
The bill enables increased expensing on new equipment and other Section 179 property, effective Sep. 27, 2017, through 2023. Tax writers give an incentive to businesses to invest in automation and other capital investments, including robots. If a pass-through entity increases capital investment in equipment, it will increase its use of the lower 25% PTE rate, which applies to capital only, not labor.
The bill does not reduce the burden of businesses paying approximately 9% of wages as payroll taxes for most middle-income employees. Employers pay half of Social Security and Medicare taxes, and employees pay the other half. Employers also pay federal and state unemployment insurance and workmen’s compensation expenses. The company may only deduct payroll costs over the useful life of a worker. Conversely, companies get an upfront tax deduction on capital equipment, like robots, which are not subject to payroll tax costs. These fiscal incentives run counter to the title “Tax Cut & Jobs Act.”
• No reduction of interest expenses for a small business
The bill allows small businesses to deduct interest expenses. A trading business should be considered a small business. Investors may have an itemized deduction for investment interest expense to the extent they have investment interest income. The bill limits net business interest deductions for big businesses.
• No entertainment expenses
The bill repeals a deduction for entertainment, amusement, or recreation activities. It retains the 50%-deduction of meals held for business purposes.
• State and local tax deductions
Tax writers dealt with substantial blowback from members of Congress in high-tax states on repealing all state and local tax itemized deductions (SALT). It raises $1.3 trillion to help pay for corporate tax cuts. Tax writers caved into pressure to allow an itemized deduction for real property taxes up to a limit of $10,000 per year, helping states that don’t have an individual income tax like Texas. But it continues to hurt high-income tax states like California, New York, New Jersey, Connecticut, and Massachusetts.
The bill’s summary lists the SALT deduction in the Table of Contents, which states: “Repeal of deduction for certain taxes not paid or accrued in a trade or business.” I am pursuing the idea of allocating a portion of SALT deductions to a pass-through entity (PTE) business reported on Schedule E or Schedule C.
• Housing-related tax benefits
The bill whittles down the limit on mortgage interest deductions. Years ago, Congress limited home acquisition debt on a primary residence and a second home to $1 million. This bill further reduces this limit to $500,000 on new home acquisition debt originated on Nov. 2, 2017, or after, and only on the primary residence. Existing mortgages before this date are subject to the prior limitation rules. The bill does not allow new home-equity loans, previously allowed up to a limit of $100,000.
“It’s going to be a nightmare keeping track of grandfathered mortgages vs. new mortgages,” says my partner Darren Neuschwander, CPA.
The bill makes it harder to use the exclusion of a capital gain on the sale of a primary residence. The exclusion amount remains at $250,000 single and $500,000 married, but the taxpayer must own and use a home as a principal residence for five out of the previous eight years, up from two out of the previous five years. There are also new income limits, which phase out the exclusion.
Taxpayers with high property taxes are still unhappy with the $10,000 limit. If they live in a state with high-income taxes, and expensive homes, they may face a tax hike under this bill. Traders and investment managers are mobile, and this bill gives them added incentive to move from a high-tax state to a tax-free state. They may have trouble selling a home priced well over $500,000. Homebuilders and realtors oppose the bill for these and other reasons.
• Alternative minimum tax
Most of the financial media are missing a critical point. By repealing many itemized deductions, it’s almost like tax writers adopted AMT as the prevailing tax regime. Why abolish the 28% minimum tax rate on wealthy individuals? That’s a massive tax cut for the wealthiest taxpayers.
• Medical and casualty loss deductions
The timing is terrible: Americans are increasingly getting stuck with escalating out-of-pocket medical bills because they cannot afford health insurance or deductibles are very high. If Congress repeals the Obamacare individual mandate (perhaps in an amendment to this bill), more people will choose to be uninsured.
Climate change is destroying houses and other property from an increased number of more powerful hurricanes and wildfires. Losing the casualty deduction is unfair. (The recent hurricane disaster relief bill allowed victims to add a casualty loss to their standard deduction.)
• Reversals of Roth IRA conversions
An essential feature of a Roth IRA conversion, where the taxpayer converts a traditional IRA to a Roth IRA, is the ability of the taxpayer to change his mind in the following year and reverse the rollover transaction. In a Roth conversion, you pay taxes on the converted value, and then the Roth IRA is permanently tax-free. But if the Roth account drops precipitously in value soon after the conversion, or before Oct. 15 of the subsequent year, the taxpayer currently is entitled to reverse the rollover. The new bill repeals the right to do this, so I expect it to have a chilling effect on Roth IRA conversions. This bill provision takes effect in 2018, so you can still reverse a 2017 Roth conversion before Oct. 15, 2018. Tax writers want to prevent taxpayers from gaming the system.
• NOL carrybacks
The bill repeals the right to do an NOL two-year carryback. It changes the 20-year carry forward to an unlimited carry forward. That’s not a good trade-off: Businesses, including TTS traders with Section 475 MTM ordinary losses, depend on NOL carrybacks to generate immediate tax refunds to refinance and stay in business. Repealing NOL carrybacks may lead to more loss of jobs. Additionally, “taxpayers would be able to deduct an NOL carryover only to the extent of 90 percent of the taxpayer’s taxable income (determined without regard to the NOL deduction).”
• Professional gamblers with net losses
The current code limits gambling losses to winnings, so gamblers, professional or not, may not deduct net losses. A professional gambler may have a net business loss deduction for business expenses only. The bill repeals all losses: Professional gambling expenses together with wagering losses are limited to income from winnings.
• Like-kind exchanges only for real property
The bill limits Section 1031 like-kind exchanges to real property. Many cryptocurrency traders were inappropriately using like-kind exchanges on coin-to-coin trades, and the bill expressly rules it out for an intangible property like cryptocurrency, and art and collectibles.
If you have any questions, please contact us soon.