On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”) was signed into law, making significant changes to certain sections of the Internal Revenue Code of 1986, as amended (the “IRC”). The Act is lengthy and complex, and a complete analysis of the Act is therefore beyond the scope of this alert. However, due to the fact that the Act is the most significant piece of federal tax legislation enacted in over thirty years, all taxpayers should have at least a general understanding of key changes made by the Act. This alert is intended to provide a brief summary of key provisions of the Act that impact federal individual, estate and gift taxes. Although significant provisions in the Act relate to corporate, pass through and international taxation, those subjects are not covered in this summary.
INDIVIDUAL AND FIDUCIARY INCOME TAXES
The Act retains the number of individual income tax brackets at seven, but generally reduces the tax rates. The estate and trust income tax structure now consists of 10%, 24%, 35% and 37% rates.
As illustrated by the chart below, the top individual income tax rate is now 37% (down from 39.6% percent in 2017) and applies to taxpayers with income in excess of $500,000 ($600,000 for joint filers). Trusts and estates continue to reach the highest tax bracket after only $12,500 of taxable income. The new tax brackets are indexed for inflation after 2018, but will sunset and revert to the 2017 effective rates (adjusted for inflation) on January 1, 2026, assuming Congress does not act to the contrary.
New Tax Rates and Brackets
|Rate||Single||Head of Household||Married Filing Jointly||Estates and Trusts|
|10%||Up to $9,525||Up to $13,600||Up to $19,050||Up to $2,550|
|12%||$9,526 to $38,700||$13,601 to $51,800||$19,051 to $77,400|
|22%||$38,701 to $82,500||$51,801 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$82,501 to $157,500||$165,001 to $315,000||$2,551 to $9,150|
|32%||$157,501 to $200,000||$157,501 to $200,000||$315,001 to $400,000|
|35%||$200,001 to $500,000||$200,001 to $500,000||$400,001 to $600,000||$9,151 to $12,500|
|37%||Over $500,000||Over $500,000||Over $600,000||Over $12,500|
As estates and trusts continue to be subject to very compressed income tax brackets (and reach the highest bracket after only $12,500 of taxable income), it is encouraged to consider appropriate planning such as timing of distributions and estate fiscal year elections.
Tax Rates on Long-Term Capital Gains and Qualified Dividends
The Act does not make any real changes to the capital gains structure. The definitions of long-term and short-term capital gains remain the same, with the former (including qualified dividends) being subject to preferential rates of tax of either 0%, 15% or 20%, and the latter being subject to ordinary income tax rates. The Act simply revises the thresholds at which the 0%, 15% and 20% capital gains rates apply. The below chart illustrates the different rates to be applied depending upon the amount of adjusted net capital gain. These thresholds are adjusted for inflation after 2018, but sunset on January 1, 2026.
|Tax Rate||Threshold for Single Filers||Threshold for Joint Filers||Threshold for Estates and Trusts|
|0%||Up to $38,600||Up to $77,200||Up to $2,600|
|15%||$38,601 to $425,800||$77,201 to $479,000||$2,601 to $12,700|
|20%||Above $425,800||Above $479,000||Above $12,700|
The Kiddie Tax
The Act simplifies the computation of the “kiddie tax,” which is imposed on the unearned income of certain children under age 19 (under age 24 for full-time students). Under prior law, such child’s unearned income was taxed at his or her parents’ rates. For tax periods 2018 through 2025, the kiddie tax is computed by applying the ordinary and capital gains rates applicable to trusts and estates to the net unearned income of the child above a certain threshold amount ($2,100 and adjusted for inflation). While these rules apply, children subject to the kiddie tax will not be affected by the tax situation of their parents; however, the unearned income of some children may be taxed at higher rates than his or her parents due to the compressed estate and trust tax brackets. The earned income of children continues to be subject to the tax rates imposed on single filers.
Child Tax Credit
For tax periods 2018 through 2025, the Act increases the child tax credit to $2,000 (formerly $1,000) per qualifying child under age 17. The credit is refundable up to $1,400 per qualifying child, adjusted for inflation after 2018. The Act also increases the threshold amount of adjusted gross income at which point taxpayers are subject to phase out of the credit. For the next 8 years, taxpayers with adjusted gross income of less than $200,000 ($400,000 for married filing jointly), are not subject to phase out of the credit. The definition of a qualifying child remains the same; however, for tax periods 2018 through 2025, the Act also provides a $500 non-refundable credit on account of qualifying dependents who are not qualifying children.
Increased Standard Deduction and Suspension of the Personal Exemption
The Act suspends the personal exemption for tax years 2018 through 2025 by making it $0 ($4,050 in 2017), and increases the standard deduction from $6,350 ($12,700 for married taxpayers filing joint returns) in 2017, to $12,000 ($24,000 for married taxpayers filing joint returns). The enhanced standard deduction figure is indexed for inflation after 2018, and returns to the 2017 figure (adjusted for inflation) on January 1, 2026. The additional standard deduction for taxpayers age 65 or older remains ($1,300 for 2018).
As a result of the almost doubling of the standard deduction and the vast limitations on and elimination of certain itemized deductions (discussed below), many taxpayers will find themselves claiming the standard deduction over the next eight years.
The Act made significant changes to some of the most popular itemized deductions claimed by individual taxpayers, such as medical and dental expenses, mortgage interest, state/local income and real estate taxes, personal casualty and theft losses, and charitable contributions.
Medical and Dental Expenses
Prior to the Act, taxpayers who itemized their deductions could deduct their unreimbursed medical and dental expenses to the extent that such expenses exceeded 10% of their adjusted gross income; however, for tax periods 2013 through 2016, a reduced 7.5% floor for medical expenses applied if a taxpayer or the taxpayer’s spouse had reached age 65. Notwithstanding, the reduced 7.5% floor did not apply for purposes of computing the alternative minimum tax (“AMT”).
The Act retroactively extends the reduced 7.5% floor for medical expenses for 2017 and 2018, and applies to all taxpayers who itemize deductions, regardless of age. For these years, the 7.5% reduced floor for medical expenses also applies for AMT purposes.
State/Local Income and Real Estate Taxes
Prior to the Act, individual taxpayers could deduct state and local income taxes, in addition to real estate taxes. For tax periods 2018 through 2025, the Act limits the maximum annual deduction that may be claimed on account of these items to a total of $10,000. It is important to note that the $10,000 limitation does not apply to real property taxes attributed to real estate held for the production of income.
For tax periods 2018 through 2025, the Act modifies the mortgage interest deduction by: (1) suspending the deduction of interest on any home equity indebtedness; and (2) reducing the maximum allowable amount that may be characterized as acquisition indebtedness to $750,000; however, debt incurred on or before December 15, 2017 remains subject to the pre-Act $1,000,000 acquisition indebtedness limitation. Refinances of pre-December 15, 2017 debt are grandfathered, and are not subject to the reduced $750,000 limitation.
For tax periods 2018 through 2025, taxpayers who itemize deductions may deduct in the year of contribution the amount of their contribution to certain charities, limited to 60% of the taxpayer’s adjusted gross income. The 60% limitation of adjusted gross income is increased from the pre-Act limitation of 50% of adjusted gross income in an effort to incentivize charitable giving.
Beginning in the 2018, the charitable deduction is disallowed for contributions to colleges or universities if such contribution is in exchange for the right to purchase tickets or seating for an athletic event. Prior to the Act, 80% of the payment would be treated as a charitable contribution. This change is permanent and does not sunset in 2026.
Personal Casualty and Theft Losses
Personal casualty and theft losses are not deductible for tax periods 2018 through 2025, unless they result from a federally declared disaster.
Miscellaneous Itemized Deductions
For tax periods 2018 through 2025, the Act eliminates all miscellaneous itemized deductions that are subject to the 2% floor. These include, most notably, investment advisory fees and other expenses for the production or collection of income, unreimbursed employee business expenses and tax return preparation fees.
Overall Limitation on Itemized Deductions
The Act eliminates the overall limitation on itemized deductions (also known as the “Pease limitation”) for tax periods 2018 through 2025. Under the Pease limitation, the total of otherwise allowable itemized deductions was reduced by 3% of the amount by which the taxpayer’s adjusted gross income exceeded a threshold amount ($261,500 for single taxpayers and $313,800 for married filing jointly in 2017); however, this overall limitation could not reduce itemized deductions by more than 80%.
The Act permanently expands the definition of the term “qualified higher education expenses,” under Section 529 of the IRC to include expenses for elementary or secondary public, private or religious school tuition. Now up to $10,000 per year (per student) can be paid from 529 accounts for tuition expenses of the student’s attendance at elementary and secondary school, and will be treated as an income tax-free distribution. This change is permanent and does not sunset in 2026. This is a very attractive addition to 529 accounts; however, gift trusts should be considered as an alternative measure.
Discharge of Student Loan Indebtedness
Eligible student loan balances discharged between 2018 and 2025, as a result from the student’s death or total and permanent disability, are excluded from gross income. Prior to the Act, this was generally not the case.
Effective for divorce decrees and separation agreements executed after December 31, 2018, the Act repeals the deductibility of alimony payments made by the payor spouse, and excludes the alimony payments from the recipient’s gross income. This is a significant change, because the tax deductibility and gross income inclusion have been historically used as factors when determining the amount of alimony.
It is important to note that this change does not affect divorce decrees or separation agreements executed prior to 2019. The Act also makes it clear that any grandfathered decree or agreement modified on or after January 1, 2019, is generally not subject to these new rules unless the decree or agreement specifically provides otherwise and refers to the Act.
The tax rules for child support remain unchanged so that support payments are neither included in gross income of the recipient, nor deductible by payor.
Roth Conversion Recharacterizations
The Act eliminates to ability to recharacterize (or unwind) any Roth conversion occurring on or after January 1, 2018, as was permitted in certain circumstances under prior law. Other recharacterizations continue to be permitted if certain requirements are met.
Alternative Minimum Tax
The AMT regime is a set of complicated rules by which individuals recalculate their tax liability and pay the greater of the AMT liability and their income tax liability computed under the general rules. Fortunately, fewer taxpayers will have to worry about the AMT over the next eight years as the exemptions are increased.
AMT is computed by adding or subtracting certain AMT adjustments and adding AMT preferences to the taxpayer’s regular taxable income for the year in order to arrive at alternative minimum taxable income (“AMTI”). The AMTI is then reduced by the AMT exemption; however, the exemption is phased out for certain taxpayers. In 2017, the AMT exemption was $54,300 ($84,500 for married filing jointly), and the exemption was phased out by the amount equal to 25% of the amount by which the taxpayer’s AMTI exceeded $120,700 ($160,900 for married filing jointly).
As a result of the significant limitation and suspension of certain itemized deductions, the AMT exemption and the phaseout thresholds are significantly increased for tax periods 2018 through 2025. The AMT exemption is $70,300 ($109,400 for married filing jointly) in 2018, and begins to phase out after $500,000 of AMTI ($1,000,000 for married filing jointly). It should be noted that for most taxpayers, at least for the next eight years, AMTI should more closely reflect taxable income due to the limitation and elimination of certain itemized deductions. This will result in less AMT being paid.
No changes were made to the AMT exemption or phase out threshold for estates and trusts.
ESTATE, GIFT AND GENERATION-SKIPPING TRANSFER TAXES
Although estate tax repeal was heavily pushed by Republicans, the Act retained the federal wealth transfer taxes, but doubled the exemptions for tax periods 2018 through 2025. The increased exemptions sunset as of January 1, 2026, and revert to the 2017 exemptions (adjusted for inflation) unless Congress acts to the contrary.
The 2018 estate and gift tax basic exclusion amount is now approximately $11.2 million for U.S. persons (previously $5.49 million in 2017). As the federal generation-skipping transfer tax (“GST”) exemption is tied to the basic exclusion, U.S. persons also have $11.2 million of GST exemption. The federal estate, gift and GST tax rates remain at 40%, and portability allows the unused portion of a decedent’s estate and gift (but not GST) exemption to be transferred to his or her surviving spouse if certain requirements are met.
The annual exclusion from gift tax is now $15,000 per donee. Spouses may continue to elect to split gifts if certain requirements are met.
No changes were made to the limited estate and gift tax exemption for non-U.S. persons, which remains at $60,000.
As a result of the increased exemptions, persons with estate tax or GST formula clauses in their wills or revocable trusts should revisit their estate planning, and make a decision as to whether changes are needed so that current provisions do not lead to unintended results.
Stepped-Up Basis Preserved
As Section 1014(a) of the IRC is not affected by the Act, heirs and beneficiaries receiving assets that are included in a decedent’s gross estate for federal estate tax purposes generally benefit from a new tax basis in each asset equal to the asset’s fair market value at date of death. This is true even if no estate tax is due and an estate tax return is not required as a result of the large exemption. This results in all pre-death gain being eliminated for most assets.
Due to the large exemptions from the federal estate tax, obtaining a new basis at death is now the focus for most. In appropriate situations, decisions may need to be made regarding whether to terminate an irrevocable trust in order to achieve potential income tax savings. Theses decisions will need to include a discussion of the more important non-tax factors for keeping a trust structure in place.
State Death Taxes Remain a Consideration
Although very few estates will be subject to the federal estate tax, state death taxes must still be considered. As of January 1, 2018, the New Jersey estate tax is repealed; however, with a new governor in office, stay tuned for whether any efforts to reinstate the estate tax will be made. The New Jersey inheritance tax remains in place and must be considered. The inheritance tax imposes a tax on most transfers to beneficiaries other than spouses, children, grandchildren and a few other exceptions. Pennsylvania also imposes an inheritance tax on certain transfers to non-spouse beneficiaries.
Disclaimer: This summary of tax and legal issues is published for informational purposes only. It does not dispense legal or tax advice, or create an attorney-client relationship with those who read it. Readers should obtain professional legal or tax advice before taking any action.