Surprises in the new tax law
How quickly things can change.
It took less than three months for serious tax reform discussions -- from Sept. 27, 2017, to the president's signature just before Christmas -- to turn the "Unified Framework for Fixing Our Broken Tax Code"1 concept into law.2
Beyond the highlights already widely reported, there are some surprises in the new law of which you should be aware.
The tax reform effort itself
Unlike the last major tax overhaul, the Internal Revenue Code of 1986, this most recent effort is more in the nature of tax changes and temporary suspensions. Many provisions expire after 2025, with corresponding sections suspended rather than repealed. The new law even starts with the statement that it is an amendment of the 1986 Code.
Some of the changes, such as the increased standard deduction threshold, have been covered in the media. What follows are the lesser-known provisions in the tax reform bill that may impact your clients.
- Head of household. Even though personal exemptions for dependents are repealed, the head of household filing status remains. A due diligence tax preparer requirement is added -- beginning with 2018 returns -- with an associated $500 penalty for each failure to be diligent in determining eligibility to file as head of household.3
- Nonchild dependent credit. In addition to a higher child tax credit, a family member tax credit of $500 for each dependent is provided.4 This may partly compensate for the loss of the personal exemption.
- Alimony. Alimony will be neither taxable nor deductible for divorce or separation agreements executed after Dec. 31, 2018.5
- State and local taxes. In a Nov. 9, 2017, letter to Rep. Earl Blumenauer of Oregon, Ways and Means Committee Chair Kevin Brady said passthroughs would not be able to deduct state and local income taxes. This would preclude allocating a portion of income taxes disallowed on Schedule A, "Itemized Deductions," to Schedule C, "Profit or Loss From Business (Sole Proprietorship)," or to Schedule E, "Supplemental Income," partnerships and S Corporations. This position is reflected in the new tax law.6
- Mortgage interest. The home equity line of credit (HELOC) interest expense is suspended through 2025.7
- Net investment income tax. The blueprint for tax reform in June 2016 assumed that the 3.8 percent net investment income tax included in the Patient Protection and Affordable Care Act would be repealed as part of the proposals from the health care task force. That did not happen, and the 3.8 percent tax is retained in the new law.8
- REITs and publicly-traded partnerships. For purposes of computing the 20-percent deduction for qualified business income, qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income are included.9 The accuracy-related penalty applies when there is an understatement of 5 percent of the tax required to be shown on the return, rather than 10 percent.10
- 529 plans. Distributions of up to $10,000 per year for elementary and high school students are permitted.11
- Cash method of accounting. Returns for 2018 will include an automatic change in accounting method for taxpayers electing the cash method under the expanded $25 million gross receipts test.12
- Limitation on losses. There is now a $500,000 limitation on business losses of noncorporate taxpayers. Disallowed losses will carry forward.13
- 50 percent of meals (not entertainment). No deduction is allowed for entertainment expenses.14 This will disallow greens fees, sporting event tickets and other items for client and customer entertainment.
- Local lobbying. No deduction is allowed for local lobbying.15 This may affect real estate developers and other businesses lobbying county and city governmental bodies, and the law firms and political consultants that provide the lobbying services.
- Transportation benefits. No deduction is allowed for transit passes or parking.16 This may result in a taxable fringe benefit to employees.
- Employer-reimbursed tax tuition for master's programs. Section 127, "Educational Assistance Programs," is retained, but miscellaneous deductions are suspended.17 While many employers may use the $5,250 per year limit for budgeting purposes, they may not have adopted a separate written plan. Instead, they may have relied on Section 132(d), "Working Condition Fringe Defined." The rationale for not including a working condition fringe benefit in income is that, if the employee paid the expense, the payment would be allowable as a trade or business expense of the employee.
With unreimbursed employee expenses (such as job education listed on Schedule A, "Itemized Deductions") suspended as a miscellaneous deduction, employer-provided graduate tuition will be taxable in the absence of a Section 127 plan.
- Interest expense. A real property trade or business can elect out of the limitation on interest expense deductibility, but then may not use 100 percent bonus depreciation.18
- Rehabilitation credits. Rehabilitation credits are limited to certified historic structures, with a 24-month transition rule for existing projects.19
- Luxury automobiles. Depreciation limits on luxury automobiles have been increased significantly.20
- Temporary 100 percent expensing of new or used property. The Unified Framework proposal allowed businesses to immediately write off the cost of investments in depreciable assets, other than structures, placed in service after Sept. 27, 2017.21 The term, "placed in service," means the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function.22 Therefore, it is possible that the purchase date and the placed-in-service date differ.
- Section 179 expensing. The definition of qualified real property has been expanded to include roofs, heating, ventilation and air-conditioning (HVAC) property, fire protection and alarm systems, and security systems.23
- Technical terminations. The technical termination rule that caused two short-period Forms 1065, "U.S. Return of Partnership Income," in a single tax year is repealed.24
- Former C Corporation converting back. When an S Corporation (that formerly was a C Corporation) is converting back to a C Corporation within two years of the date of enactment of the new tax law, distributions during the post-termination transition period are pro rata from the accumulated adjustments account (AAA) and from earnings and profits (E&P). This prevents a distribution of the tax-free AAA account only. If there is accumulated E&P from the former C Corporation, a pro rata portion of the distribution will be a taxable dividend.25
- Limitation on interest expense. Interest expense is limited to 30 percent of taxable income, with an exception for small businesses.26
- Net-operating losses. Net-operating loss (NOL) carryforwards may offset only 80 percent of taxable income, resulting in a tax of 4.2 percent in a profitable carryforward year.27 (Twenty percent of taxable income taxed at the 21 percent corporate tax equals 4.2 percent tax.)
- Repatriation of deferred foreign income. Unless a state provides a dividends-received deduction for foreign dividends, the repatriation of foreign profits might be subject to multistate taxation. For federal tax purposes, deferred foreign income is treated as Subpart F income from a controlled foreign corporation and taxed at an 8 percent rate for nonliquid foreign income, and a 15.5 percent rate on cash. The federal tax is payable in eight installments.28
Tax research tip
The Joint Committee on Taxation -- the internal tax advisers to Congress -- posted a technical explanation of the new law.29 It is a plain-English explanation of the current law, reasons for the change, and the effective date of each new tax law provision. This technical explanation can be an extremely useful tax research tool, and constitutes a source of substantial authority for avoiding accuracy-related penalties.30
Mark Sellner, CPA, JD, LLM (taxation) consults with CPAs and their clients on business and executive tax matters, including partnership taxation and the tax consequences of buying and selling a business. He is a member of the MNCPA and Florida Institute of CPAs. You may reach him at firstname.lastname@example.org.
2 All references to Internal Revenue Code sections are as amended by the new law.
3 IRC Section 6695(g)
4 IRC Section 24(h)(4)
5 IRC Sections 215 and 71 repealed
6 IRC Section 164(b)(6)
7 IRC Section 163(h)(3)(F)(i)
8 IRC Section 1411
9 IRC Section 199A(a)
10 IRC Section 6662(d)(1)(C)
11 IRC Sections 529(c)(7) and (e)(3)(A)
12 IRC Section 448(d)(7)
13 IRC Section 461(l)
14 IRC Section 274(n)
15 IRC Section 162(e)
16 IRC Section 274(a)(4)
17 IRC Section 67(g)
18 IRC Section 163(j)(7)(B); IRC Section 168(k)(9)
19 IRC Section 47(a)
20 IRC 280F(a)(1)(A)
21 IRC Section 168(k)(6)
22 Reg. Sec. 1.167(a)-11(e); Reg. Sec. 1.179-4(e)
23 IRC Section 179(f)
24 IRC Section 708(b)
25 IRC Section 1371(f)
26 IRC Section 163(j)(1) and (3)
27 IRC Section 172(a)
28 IRC Section 965
30 Reg. Sec. 1.6662-4(d)(3)(iii)