The Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law by President Donald Trump on December 22, 2017. The Act changes many provisions of the Internal Revenue Code, from individual and business provisions, to matters affecting pass-through and tax-exempt organizations. The Act is generally effective starting in 2018.
In this summary, we address the major issues that will affect our clients in the healthcare industry. If you have any questions regarding the Act, please contact a Schwabe attorney.
Modifications to capital gain provisions. The Act generally retains present-law maximum rates on net capital gains and qualified dividends. The adjusted net capital gain of an individual, estate, or trust is taxed at maximum rates of 0%, 15%, or 20%. It retains the breakpoints that exist under pre-Act law, but indexes them for inflation using C-CPI-U. The change is effective after Dec. 31, 2017. Barring further legislation, these changes will expire after 2025.
Certain gains from partnership profits interests held in connection with performance of investment services are short-term capital gains if held for three years or less. Before the Act, gains from a profits interest in a partnership (sometimes referred to as a carried interest) typically passed through an investment partnership as long-term capital gains and, thus, were taxed in the hands of the taxpayer at more favorable rates. Thus, for the wealthiest citizens who fell into the 39.6% bracket, long-term capital gains were generally taxed at a rate of 20%.
The Act changes the tax treatment of gains from a profits interest in a partnership (carried interest) held in connection with the performance of services by providing that if one or more “applicable partnership interests” are held by a taxpayer at any time during the tax year, the excess (if any) of (1) the taxpayer’s net long-term capital gain with respect to those interests for that tax year, over (2) the taxpayer’s net long-term capital gain with respect to those interests for that tax year by substituting “three years” for “one year,” will be treated as short-term capital gain. Thus, the Act provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. If the three-year holding period is not met with respect to an applicable partnership interest held by the taxpayer, the taxpayer’s gain will be treated as short-term gain taxed at ordinary income rates. These changes are effective beginning after Dec. 31, 2017.
The Act modifies the CTC by increasing the credit amount, increasing the threshold amounts for the phaseout, and allowing a partial credit for dependents who do not qualify for a full CTC. Under the Act, the child tax credit is increased to $2,000. The income levels at which the credit phases out are increased to $400,000 for married taxpayers filing jointly ($200,000 for all other taxpayers) (not indexed for inflation). In addition, a $500 nonrefundable credit is provided for certain non-child dependents. The amount of the credit that is refundable is increased to $1,400 per qualifying child, and this amount is indexed for inflation, up to the $2,000 base credit amount. The earned income threshold for the refundable portion of the credit is decreased from $3,000 to $2,500. These changes come into effect after December 31, 2017. Barring further legislation, these changes will expire after 2025.
State and local tax deduction limited to $10,000. Before the Act, individual taxpayers were allowed an itemized deduction for state and local taxes (“SALT”) and foreign taxes, even though not incurred in a taxpayer’s trade or business.
Under the Act, individual taxpayers may not deduct foreign real property tax, other than taxes paid or accrued in carrying on a trade or business. A taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for marrieds filing separately) for the aggregate of (a) state and local property taxes not paid or accrued in carrying on a trade or business and (b) state and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the tax year. Foreign real property taxes may not be deducted under the $10,000 aggregate limitation rule. These changes come into effect after December 31, 2017. Barring further legislation, these changes will expire after 2025.
Mortgage interest deduction acquisition debt maximum is lowered to $750,000; deduction for home equity interest is suspended. Taxpayers may claim an itemized deduction for “qualified residence interest” (“QRI”) (the mortgage interest deduction). Before the Act, deductible QRI was interest paid or accrued on acquisition indebtedness that is secured by a qualified residence, or, home equity indebtedness that was secured by a qualified residence. Prior to the Tax Cuts and Jobs Act, the maximum amount treated as acquisition indebtedness was $1 million ($500,000 for married taxpayers filing separately). The amount of home equity indebtedness could not exceed $100,000 ($50,000 for a married individual filing separately).
Under the Act, the deduction for mortgage interest is limited to underlying indebtedness of up to $750,000 ($375,000 for married taxpayers filing separately), and the deduction for interest on home equity indebtedness is suspended. Taxpayers may not claim a deduction for interest on home equity indebtedness. The Act’s $750,000/$375,000 limit on acquisition indebtedness does not apply to any indebtedness incurred on or before Dec. 15, 2017. Therefore, acquisition indebtedness incurred before Dec. 15, 2017, is limited to $1,000,000 ($500,000 for marrieds filing separately). These changes apply to tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
Individual Insurance Mandate penalty reduced to zero. Under current law, taxpayers who fail to carry health insurance for themselves and certain dependents that provides at least minimum essential coverage are required to report that information on their tax return and pay a penalty (the “individual mandate”). The Act reduces this penalty to $0 beginning in 2019, essentially eliminating the impact of the individual mandate.
Section 179 deduction limits increased. For tax years beginning after December 31, 2017, the annual deduction limit for Section 179 property has been increased from $500,000 to $1 million, and the limit on purchases has been increased to $2.5 million (from $2 million). These amounts are now indexed for inflation beginning in 2018. The definition of Section 179 property has been expanded to include certain tangible personal property used in furnishing lodging as well as roofs, heating, air conditioning, and ventilation systems, fire protection, alarm and security systems installed on non-residential real property that has already been placed in service.
Temporary 100% cost recovery of qualifying business assets. For qualifying business assets acquired and placed in service after September 27, 2017, and before January 1, 2023, a 100% deduction for the adjusted basis of the assets is allowed. This repeals the current 50% deduction previously scheduled to go into effect after December 31, 2017. Starting on January 1, 2023 through December 31, 2027, this temporary bonus first year depreciation rate is reduced by 20% each year (80% for 2023, 60% for 2024, etc.) until it sunsets for years after 2026.
Deduction for business interest limited. For tax years beginning after December 31, 2017, net interest expense is generally limited to 30% of the business’s adjusted taxable income. Although this limitation is generally determined at the tax-filer level, in the case of pass-through entities, the determination is made at the entity level. For purposes of applying these limitations through January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization, or depletion deductions.
NOL deduction modified. For NOLs arising in tax years after December 31, 2017, the two-year carryback rule is repealed, other than in cases involving certain losses incurred in a farming-related trade or business. Moreover, for NOLs arising in tax years after December 31, 2017, the NOL deduction is generally limited to 80% of taxable income. NOLs may generally be carried over to future years without limitation.
New deduction for certain pass-through income. Currently, income that “passes through” a partnership, S corporation or sole proprietorship to a partner, shareholder or sole proprietor is taxed at that individual’s marginal income tax rate. The Tax Act adds a new section to the code, Section 199A, which provides a 20% deduction from individual income tax rates for “qualified business income” (“QBI”) from a partnership, S corporation or sole proprietorship to non-corporate taxpayers, including trusts and estates. QBI is generally the net income from a business minus any reasonable compensation, guaranteed payments, or other payments to partners/owners that are for services other than as a partner/owner. QBI is determined on a per-business (not individual) basis.
Generally, for businesses whose owners have individual income of less than $157,500 or file jointly with income below $315,000 (the threshold amounts), the deduction is simply 20% of QBI. For owners with income above these amounts, how the deduction is treated depends on the type of business they are in. For those in a “specified service trade or business,” which includes service businesses in healthcare, law, consulting, athletics, financial services, or where the principle asset of the business is the reputation or skill of the business’s owners or employees, such owners will see their deduction begin to be reduced starting at the threshold amounts until completely phased-out (and no deduction available) for individual income of $207,500 or $415,000 for married filing jointly. The formula for determining the reduction in the deduction calculation is based on W-2 wages paid by the business and a portion of the business’s capital assets.
For businesses that are not in a specified service trade or business, the wage and capital limits also begin to apply at the threshold income amounts and apply fully at $207,500 for individuals and $415,000 for married filing jointly. However, unlike for specified service trades or businesses, the deduction is not eliminated above these amounts. This section will be effective for tax years starting after December 31, 2017 and before January 1, 2026.
Look-through rule applied to gain on sale of partnership interest. For sales and exchanges on or after November 27, 2017, gain or loss from the sale or exchange of a partnership interest is “effectively connected” with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership must be allocated to interests in the partnership in the same manner as non-separately stated income and loss.
For sales, exchanges and dispositions after December 31, 2017, the transferee of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Tax-exempt organizations subject to excise taxes for highly paid individuals. Under current law, the compensation of executives of tax-exempt organizations is subject to a reasonableness requirement and private inurement limits, but there are not set dollar limitations on compensation of such executives. The Act imposes an excise tax on compensation to an executive over $1 million and certain “parachute payments” made to such executive. The excise tax is imposed on the tax-exempt organization and is imposed at the same rate as the corporate income tax (21% under the Act). Tax-exempt organizations that currently pay compensation to any individual executive in excess of $1 million should contact their advisor to evaluate options for minimizing the impact of this tax.
Tax-exempt organizations must separately compute unrelated business taxable income. Under current law, a tax-exempt organization computes its unrelated business taxable income on an aggregate basis, which effectively allows it to use deductions from one business activity to offset income for a different business activity. Under the Act, tax-exempt organizations must now separately compute their unrelated business taxable income for each trade or business, which eliminates the ability to offset income from one activity with deductions from a separate activity.
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