In 2017, Congress passed the most sweeping update to the tax code in 30 years. How will the new tax code affect you? I joined the team at The Spotlight on Your Wealth Podcast to discuss.
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Aaron: Welcome to Episode Number 3 of The Spotlight on Your Wealth Podcast. “In this world nothing can be said to be certain except death and taxes.” This may be Benjamin Franklin’s most famous quote. Taxes are inevitable, and taxes are contentious. In the 18th Century British taxes on the American Colonies led to an American Revolution and the founding of the United States. Congress imposed the first personal income tax almost a century later to pay for the Civil War. And in the 20th Century, Congress ratified the 16th Amendment giving itself the power to lay and collect taxes on incomes.
Contentious as they are federal income taxes are here to stay. Over the years there have been many changes to the tax code and income tax brackets. The most recent changes were enacted in 2017. Love it or hate it, this new legislation is the most sweeping update to the tax code in 30 years. Here to guide us through the changes is Kermith Boffill, who is a lead tax partner and CPA at Grobstein Teeple, an accounting (and consulting) firm with offices in California and Washington DC. Welcome Kermith.
Kermith: Thank you.
Kermith: Grobstein Teeple was started by five partners who were friends for many years and decided they wanted to get out of the big national firm and start a small consulting firm with the abilities of a national firm, but with a touch of a smaller, friendlier, more client-oriented type of boutique firm. We are now five years old and we kind of like to say that we started backwards. We started a consulting firm first and we helped in all matters of litigation support and restructuring for companies that were in trouble and now we are working our way to creating a more robust, more traditional accounting firm with tax practice. I am the tax lead and I’m taking that part of the business bigger, and we have audit, and we are doing the more traditional, more black and white type of accounting functions that will help us grow. We just celebrated our fifth year and hopefully we have got another 30, 40, 50 years to go.
Aaron: Fantastic. Kermith, tell us about your background in accounting.
Kermith: I started in private practice. I did private practice as a CFO for a company for about 15 years while I was going to school. I decided, once I got close to finishing school, I decided that you know, I might as well get into public accounting. That was in 2003 and since 2003, I’ve been working in public accounting. When I started my career, I did both audit and tax and at some point, I was made to choose. I chose, I think the beauty of both, which is tax. There are few people that need to love tax and I, fortunately, am one of them.
Aaron: Well, we’ve got the right guy for our podcast today, don’t we?
Kermith: Yes, we do.
Aaron: Kermith, we had a tax code that before 2017 that was how many pages long?
Aaron:And now after the new tax code?
Kermith: It’s probably just as big or bigger!
Aaron: That’s what I thought. All right well, let’s get into this then, please. Tell us what are some of the significant changes to the personal income tax?
Kermith: The biggest change for the personal income tax is the change in tax rates. Generally speaking, they went down anywhere between 2% to 3% per bracket and they widened the brackets. So more of your income will be subject to the lower brackets. The goal there is to have an overall depressing of the amount of taxes owed, so if last year you had $200,000 of income and your marginal rate was, say 30%, the goal now is to have more of the $200,000 taxed at a lower rate, thereby saving you taxes. That’s the biggest change. They went from having, I believe it was eight tax brackets to now six, and that was all in the spirit of lowering taxes and hopefully simplifying the application of the brackets.
Aaron: Got it, so we have fewer tax brackets-
Kermith: Fewer tax brackets, bigger range within the brackets themselves, and lower in terms of percentages as well. So, your next dollar should be tax at a lower rate.
Aaron: Got it.
Kermith: That’s taxable income.
Aaron: That’s taxable income. We know this will help reduce taxes from most taxpayers but not everyone will benefit from this, right?
Kermith: That’s right. They made some changes to the deductions that came out of the taxes paid to states. Those are severely limited and so if you happen to reside in California or New York or some other state like-even Illinois has a little bit of an elevated tax rate, you are capped. You can’t take more. So, if you have $200,000 as I have used in my previous example and you are at a 10% marginal rate, for state purposes you owed $20,000 of taxes roughly. Under the old rules you would be able to deduct those $20,000 without impediment.
Now under the new rules, you’re capped at $10,000 so even though you paid to your state $20,000 you can only deduct $10,000. So, it’s a bit of a penalty for those high taxed states. While I said earlier that your taxable income is exposed to lower brackets, now because of the deduction limitations to state taxes, primarily your taxable income will be higher. So instead of having the $200,000 of taxable income you had previously, it’s not going to be $210,000 because you have to pick up the undetectable portion of your state taxes.
Aaron: Got it, so if you live in a high tax state, California, Illinois or New York-
Kermith: New York, right tax states you’re at a disadvantage.
Aaron: You are at a disadvantage.
Kermith: There are certain states that’s coming up with some creative ways of trying to get a deduction, bypass the Federal limitations, but we’ll see how that goes. I don’t think it’s going to happen, but we’ll see.
Aaron: For the people in those high-income states, it might just be a wash. They’re paying lower federal income tax brackets but because of this cap on the state income tax, it may just be a wash.
Kermith: That’s right and one of the things that will likely help out those people in the high-income tax states is AMT limitations rose considerably. So, while last year’s brackets captured a lot more people in the AMT, which stand for Alternative Minimum Tax, now the limit is a million dollars of Alternative Minimum taxable income-not very many people are going to reach that. One of the adjustments to the AMT is an ‘add back’ for state taxes. Now that less and less people will be subject to the AMT, the hope is that that lack of AMT tax will make up for the lost state deductions. We’ll see how it all plays out but that’s the theory behind it.
Aaron: Got it. And the Alternative Minimum Tax, the AMT, was something that was passed by Congress many decades ago and was never indexed for inflation, so it was initially set up to tax people in the higher income tax bracket but then it turned out that a lot of people in the middle got caught up in the AMT.
Kermith: Yes, and in every year, more and more middle-class people were, at least were respect to the AMT, defined as rich. Which we all know is not the case.
Kermith: So, I think last year if you were somewhere around $200,000, which in a state like California and New York is pretty common, you likely were in AMT. And so now you will not be in AMT although you don’t get to deduct the state taxes. You will no longer have to pay that AMT so hopefully you balance out that way.
Aaron: And then there are also major changes to the deductions-the standard deduction. Can you tell us a little bit about that?
Kermith: Yes, so it used to be that you got, depending on your filing method. If you are filing single, you would get a standard deduction, which was about $6,000 and change, and then if you were filing as married filing couple, for example, you would get another deduction. Now what they did was they said, no we’re going to do away with that. We’re going to do away with your standard deduction and your exemptions.
A family of four would get $4,000 per person being reported on the tax returns so a family of four could have realized somewhere between, actually it was about $16,000 of exemptions on their tax return. That’s gone, so what they said was a single individual will get $12,000 of standard deduction, and a married filing jointly couple, regardless of how many dependents they have, will get $24,000.
The purpose behind that was to twofold (1) To try to make up for some of those lost deductions and (2) To simplify the compliance portion of filing tax returns. The theory is that now under the larger standard deductions, less and less people will be incentivized to itemize their tax returns thereby making the filing a lot simpler process-you don’t have to do a Schedule A, you don’t have to itemize, to have to keep receipts for certain things. And so, that’s the goal. We’ll see how it all plays out, but that’s goal.
Aaron: Okay so it might simplify things, but it might also be a penalty for people with a lot of kids.
Aaron: So, don’t have lots of kids.
Kermith: Unless you really want them.
Aaron: Unless you really want them but don’t do it for tax purposes.
Kermith: That’s right.
Aaron: Are there any other personal Income tax issues that are a dramatic change from the previous year?
Kermith: Yes, there are. One of the things that going into the tax negotiations at the end of 2017 was they wanted to simplify the tax code. They wanted to simplify it so much that CPAs were like, we’re going to be put out of a job. One of the concerns that had as this law was being formulated and negotiated and ultimately passed was that compliance was going to be so easy that it would put all of us out of a job. It turns out that rather than simplifying some of these issues they really, really, really made it a little more complicated.
What I mean by that, there is something called a “Qualified Business Deduction” for those people who own their own businesses. That is a really big change to the tax code and it’s a change that is causing practitioners a lot of consulting time, a lot of questions, a lot of research because we ourselves don’t understand it entirely. What’s happening is they are coming out with regulations and guidance. As they come up with that, they need to determine what that guidance is.
Generally, what this QBI deduction intends to do is equalize the changes in the corporate tax law with those people who have businesses that would otherwise be changed to the corporate structure to take advantage of the lower tax rate. So now they are trying to make it, so they prevent business owners from changing say an LLC, for example, into a C-corp. That’s what they’re trying to prevent and so they come up with this QBI deduction that is really really complicated. I think maybe it’s outside the scope of this conversation but it’s really complicated and it’s something that’s out there and for those of your clients that have these types of pass-through entities: S-Corps, LLCs, Schedule C businesses where there’s a sole owner/sole practitioners to really consult their tax advisor because it is very important, probably the most important thing that came out of this tax law.
Aaron: To go back to the origins of this of the tax law, part of it was really to a big deduction for corporations.
Kermith: Yes. So, in other words, it was to bring down the corporate tax rate which was very similar to the individual tax rate. What I mean by that-it was progressive in nature so the more income you earned the higher you got taxed. And so that’s how corporate law used to be. If you hear, that was all over the news. We have the highest corporate tax rates in the world, they impede business and all these things.
Truth is, yes it does impede business but very few corporations ever paid that high tax bracket because they had accountants who would help them mitigate some of that impact of the high progressive tax rates. So, the whole thing was like, it’s impeding businesses, we have to change it, and so they came up with the flat tax rate which is 21%. How they determine 21% is still unclear to me but I have my theories. But I think that 21% automatically got everyone thinking, “Wow I have an S-Corp, I have an LLC, I’m just going to switch to a C-Corp and pay 21%. Why am I going to pay my high tax rates when I can pay my tax at a C-Corp level?” The government saw this. The people that were writing this document, Gary Cohen who’s a brilliant guy, he saw this and decided he had to come up with something to prevent an exodus of taxpayers converting their S-Corps and LLCs into C-Corps.
So, what he did was, he came up with this QBI deduction and it’s supposed to equate the benefit you get from a C-Corp to an LLC and a S-Corp. The only problem is C-Corp tax reductions are permanent and individuals are not. As a matter of fact, most of the changes they made to the individual taxes only are in effect from 2018 and they expire in 2025, which makes it kind of hard because if you are planning for long-term growth of a company whose currently an LLC or an S-Corp, it’s very hard because you don’t know what’s going to happen after 2026. My hunch is that it will be extended because once a policy is put into effect and enough people like it, it kind of becomes politically impossible to change. And so, I think it will stay that way but that’s just my guess.
Aaron: Congress tried to simplify something and instead they mucked it up.
Kermith: Go figure.
Aaron: If you are a business owner, is there now a difference between an S-Corporation, LLC, or Sole Proprietorship?
Kermith: The difference between those three types of entities is more related to a C-Corp. They are more similar than they are not similar. They differ most from a C-Corp. The LLC and the S-Corp will still pass the through. The biggest difference between the S-Corp and the LLC is how the income is taxed. From an LLC, it’s subjected to taxes that an S-Corp is not subject to, namely self-employment taxes. In an S-Corp, they’re not applicable but you have to draw a wage in which you get a paycheck. That is how you pay the self-employment taxes. Whereas an LLC, you don’t have to do that but all of the income is subjected to self-employment taxes. With a sole proprietor/Schedule C for example, your whole taxable income, in other words the money you make from that activity, is all subjected to self-employment tax. They are very similar. The only difference is how they’re structured but in terms of the ultimate effect on the individual, they are very similar.
Aaron: Let’s talk a little bit about the changes to estate taxes.
Kermith: That’s actually a great planning source, a great area of the new tax law that allows us to do some planning, especially with respect to people who exceed the thresholds. Just generally speaking, what changed was, there was a 5.6 limitation –
Aaron: 5.6 million dollars.
Kermith: 5.6-million-dollar limitation on how much a person could leave to his or her heir without paying any estate taxes on it. The new tax law changed that from 5.6 to 11.2 per person. It would be 11.2 million dollars per taxpayer that they can leave to their heirs. There is kind of a wrench in the whole thing, and that is again as I mentioned earlier this portion of the law is set to expire in 2025. While earlier I said that sometimes when a law is very popular it affects a lot of people, it’s hard to change. I think in this case you may have the opposite effect because very few people will benefit from this and so it may change. That offers accountants and practitioners a good grey area in which to operate and plan.
There are very different ways that you can take this. One of the constraints is obviously we don’t know if this is going to permanent forever. And then lastly, what happens if you take advantage of an exemption today or you gift something to try and take advantage of your exemption but it’s a property and you lose the step-up that you would otherwise get. There is some planning where we are trying to gift out the assets a taxpayer has so that we can take advantage of the 11.2. The reason we’re doing that is because, if it changes in 2025 and it goes back to $5 million or even prior to that, I believe in 2000 it was $600,000, if it goes back to those numbers, they’ve already utilized the 11.2 million dollars of exemption and they can’t take it back. So, you’ve already given all of these assets tax-free, which is a great thing, especially for your heirs. You don’t have to pay any taxes on it. We’re looking into strategies to utilize that.
The other one is if you do happen to have a tax payer pass away and they did not use their 11.2 exemption, you have what’s called “portability.” Portability means that if I don’t use my exemption, I can leave it to my husband or wife. He or she will not only have their current exemption, whatever it is at that time, plus your unused portion of the spouse that previously passed away. That’s also a planning portion we’re taking advantage of.
Essentially, what we need to understand, and how people can take advantage of the new higher level of exemptions, is if they have any assets that they are intending to leave to their heirs, it’s probably better to start thinking about gifting them now when we know what the law is then waiting to 2025 when we don’t know what the law will be. Those are the two big things that changed in the estate tax law.
Aaron: Kermith, let’s go through some examples. If you would, please give us a couple of examples of how it’s different now than it was just a year ago.
Kermith: The two most common scenarios involve a married couple with two kids and an individual with no kids. Prior to last year’s changes, if you had a married couple with two dependents, two kids and you weren’t doing any itemization, you weren’t itemizing your deductions. You would just take the standard deduction. What you would get is $12,750 of standard deduction. With that you would get $16,200 in personal exemptions so you are essentially getting in total deduction $28,950. Under the new law that’s all gone. Now all you get is $24,000 of standard deduction, no exemptions. So, the big change is your standard deduction is higher, but your exemptions are gone. So, you have a decrease in total deductions under this scenario of $4,960. Depending on the income level it may mean a lot, it may mean not so much, depending on how much income that family earns.
Now a single individual with no dependents, surprisingly, does a little bit better. Under the old law they would normally get a $6,350 standard deduction plus they would get their personal exemption of $4,050. Under the new law all they get is $12,000 of standard deduction. Under the old law total deductions would have been $10,400 and under the new law, it’s a $12,000 straight standard deduction. The individual taxpayer with no dependents actually is better off by $1,600. The whole point is, every case will be different, every taxpayer situation will be different, and so some people you would least expect that will benefit do. Those who you think will most benefit may not.
Aaron: So, you got a lot of variables.
Aaron: Whether you’re single, whether you’re married, whether you have dependents, depending on what state you live in.
Kermith: That’s right.
Aaron: Whether you’re a business owner or an employee.
Kermith: That’s right.
Aaron: Kermith, along with all these other changes we’re talking about, we also have to the mortgage interest deduction.
Kermith: Yes, we do. Under the old law, you could take a million dollars of acquisition debt plus a hundred thousand dollars of line of equity to improve the house and things like that. Under the new law the total is $750,000, so that’s all you get. When they first changed the law there was a discussion as to whether or not previously existing loans would be subjected to the $750,000 limitation and it turns out that no. It’s only for loans originated when the new tax law was in effect, so after January 1st, 2017. That’s very important for houses in states that houses generally exceed $750, 000. Now for example, if you want to buy a house in our neighborhood in Woodland Hills, you’re lucky if you can find something that’s $750,000.
We are telling clients now that if they want to buy that million-dollar house, unfortunately what they can do is give a bigger down payment and get your loan balance down so the amount you finance to buy the house is under the $750,000 limit to be able to take advantage of deductions.
Aaron: Kermith, there is also now a change to what you can deduct for advisory fees. You used to be able to deduct fees paid to your accountant, to your financial advisor, and other service providers. What’s the new change?
Kermith: In a nutshell, bottom line, they eliminated that deduction. Those deductions used to be deducted in the part of your Schedule A tax return that was titled “Deductions Subject to a 2% Floor.” A lot of people took advantage of that section, advisor fees as you mention, people who pay their tax accountants to prepare their tax returns, there was a PO box deduction in there, but the largest chunk of people that took advantage of that section of the form were teachers, fireman, traveling salesman-people who paid expenses in carrying out their jobs but were never reimbursed for them-construction workers who bought steel toe boots, various professions that need to spend to get something.
Teachers were probably the biggest ones. They bought supplies out of their own pocket. They bought things they needed for the classroom for instruction. They can no longer deduct that so it’s an impact that will affect a lot of people, I think bigger than probably any other change. Union dues, PO boxes, tax accountants, all that stuff is gone. Previously you could get a nice little deduction from use of your home for business purposes that you did the reimbursement for, for example, you can no longer do that.
It’s a big impact. It will affect a lot of people. People who probably needed those deductions to begin with.
Aaron: Are there any changes to what you can deduct for health care expenses?
Kermith: It all depends on whether or not the health care expenses are done through a business or not. If you’re individually employed, you have a sole proprietorship or a C-Corp or maybe have an S-Corp or an LLC, typically you could use that pay for your insurance. Under the old law, to be able to deduct medical fees you need to exceed 10% of your AGI. So, if you had $100,000 of AGI you can deduct the first dollar once you exceed 10% of your AGI which would have been $10,000, so on $10,001 when you can start deducting.
It was very hard to actually take it over. What they did is they lowered that to 7.5%. The goal is to have more and more people take advantage of that deduction and hopefully make some of the burdens of buying and paying for things related to medical a little bit easier but even then I don’t know if most people will exceed that especially because a lot of people are getting insurance through their work and the expenses they otherwise would use is minimal, but we’ll see. As part of the tax law they changed, or they eliminate the mandate under Obamacare to buy health care or have insurance. The goal of that was to create cheaper alternatives. Usually, with those cheaper alternatives the coverage isn’t as great as we have with some of the more expensive plans than Obamacare requires. And if that’s the case, you may see an increase in expenditures with respect to medical and doctors’ visits because less and less will be covered. Hopefully, with the lower 7.5% threshold, you can deduct some of that.
Aaron: Are premiums included in that 7.5%?
Kermith: If you don’t deduct it otherwise, yes. Normally, like I said earlier, if you have a business you likely would deduct your premiums through your company but if you’re not deducting them elsewhere, yes then you would be able to deduct them under Schedule A.
Aaron: To sum it up, we now see a somewhat simplified tax code for individuals who don’t have a lot of deductions or have some deductions because a lot of the deductions are going away, but now there’s a higher standard deduction. If you have a business it gets really complicated and there are a lot of moving parts, and the IRS are still issuing guidance on that.
Kermith: That’s right.
Aaron: There are new limits for mortgages, health care costs-
Kermith:Miscellaneous expenses, and there’s QBI which is not a limitation but it’s good, AMT is gone which is a good thing, and there are changes to the tax brackets-they’re widened, they’re lower. So hopefully, all in all, people come out a little bit better than they did. We see how it all plays out.
Aaron: But after listening to this podcast, I’m sure everyone who is listening thinks well, things aren’t any simpler than they were before, and I still need an accountant to help me so-
Kermith: That’s right.
Aaron: So please consult your tax professional and if you need a tax professional, the partners at Grobstein Teeple can help you out as well.
Kermith:That’s right. We’re here to help.
Aaron: This was Episode 3 of the “Spotlight on Your Wealth Podcast.” You can subscribe to our series on Apple iTunes or wherever you listen to your favorite podcasts. For Kermith Boffill and all the professionals at Grobstein Teeple and Spotlight Asset Group, thanks for listening.