You can’t go anywhere these days without hearing about those tax proposals. Tax law can be tricky. If you don’t know your personal exemption from your standard deduction, or your Schedule A from your Schedule C, I’ve got you covered. Here’s what you need to know:
1. Sunset. Most of the provisions in the Senate version of the bill that apply to individual taxpayers, including individual tax cuts, the increased standard deduction, and the expanded child tax credit, are set to expire at the end of 2025. When that happens, the law goes back to the way that it was before the provisions were implemented. When that happens, it’s called a “sunset” which, I know, sounds way prettier than it actually is.
2. Marginal Tax Rates. The top tax rate that you pay is your marginal tax rate, or the rate that you’d pay on the next dollar of income, but not the rate that you’ve paid on all income.
3. Progressive Income Tax. Our current income tax system is progressive for both people and corporations (although corporate tax tables are quirky). When you’re figuring potential tax savings under the proposed tax plan, don’t assume a flat rate at the top for either calculation – remember, those are marginal tax rates (see #2).
When running the numbers, many taxpayers figure their tax using their top rate and then comparing that amount to the tax calculated using the proposed rates. In other words, “I’m in a 39% tax rate with $200,000 in income. Rates are falling to 20%. Therefore, I save 19% or $38,000.” But that’s not how it works.
Let’s say you’re single. If you’re in 28% individual bracket for 2017, you don’t pay 28% on all income – or even on all taxable income (see #5). If you’re single, you pay the same 10% on the first $9,375 as every other single person. Then, you pay 15% on the next $27k and 25% on the next $50k – same as every other single person. You only pay that 28% on income over $91,900. That’s why we call it progressive.
So, bottom line: If you’re trying to figure how the proposed rates might affect you, make sure that you use the correct tax rates for both calculations.
4. Above the Line Deductions. To claim certain tax benefits, you have to itemize your deductions (more on that in a moment). But you can claim some tax breaks even if you don’t itemize. These are found on page 1 of your form 1040 and include teacher’s expenses, moving expenses, alimony, contributions to your IRA, the student loan deduction, and the tuition and fees deduction.
Most of these deductions are slated to disappear under the House bill. The Senate would retain certain of these deductions.
5. Taxable Income. Tax is calculated on your taxable income. Many taxpayers think that’s the number that shows up on your forms W-2 and 1099. Nope. When you add up income subject to tax, including wages, dividends and taxable interest, capital gains and losses, business and farm income, certain retirement distributions, and the taxable part of Social Security, you get to total income. After you make adjustments for above-the-line deductions (see #4), you get to adjusted gross income (AGI). But like promo for a set of Ginsu knives – wait! There’s more! You then subtract your itemized deductions OR standard deduction (and additional standard deduction if applicable) and personal exemption amounts. That amount is your taxable income.
6. Standard Deduction. You have the option of adding up your itemized deductions (see #7) and using that amount or using the standard deduction. The standard deduction amount is a flat amount based on your filing status. For 2017, those amounts are $6,350 for individuals, $9,350 for HOH, and $12,700 married couples filing jointly.
Under the House bill, the standard deduction would increase to $12,200 for individuals, $18,300 for heads of household (HOH), and $24,400 for married couples filing jointly; under the Senate bill, it would increase to $12,000 for individuals, $18,000 for HOH, and $24,000 for married couples filing jointly.
7. Schedule A. If, instead of claiming the standard deduction, you opt to itemize, you do so on Schedule A. Currently, only about 1/3 of taxpayers itemize and that number is expected to dip to about 1/10 under the proposals. Itemized deductions currently include (but are not limited to): medical and dental expenses; taxes you paid during the year including state and local income taxes (or sales taxes) and state and local property taxes; home mortgage interest paid; charitable donations; casualty and theft losses; job-related expenses; and tax preparation expenses.
Under both tax proposals, most of these itemized deductions would be eliminated. Those that are likely to remain are the charitable donation deduction; a modified home mortgage interest deduction; and a limited state and local property tax deduction (the Senate version would also retain the medical expense deduction).
8. Job & Employee Expenses. Currently, expenses that you incur in your job (not in your own business) which are not reimbursed may be deductible on Schedule A. Those expenses include tools and supplies; required uniforms not suitable for ordinary wear (like those ABBA costumes); dues and subscriptions; and job search expenses. These expenses also include unreimbursed travel and mileage, as well as the home office deduction.
Under both tax proposals, those deductions will be eliminated.
Some posts which have made their way onto social media suggest that these deductions would be eliminated for sole proprietors or other businesses. That is not the case. The elimination of unreimbursed employee expenses only affects taxpayers who claim an employee-related deduction on Schedule A (see #7). If, as a business owner, you typically file a Schedule C, your business-related deductions are not affected by the elimination of Schedule A deductions.
9. Personal Exemption Amounts. You can claim a personal exemption for yourself, your spouse, and your dependents (your spouse is not your dependent). Personal exemptions decrease your taxable income before you determine your tax (see again #5).
Under both tax proposals, personal exemptions would be eliminated and replaced by the increased standard deduction.
10. Refundable Tax Credits. A credit is a dollar for dollar reduction in the amount of tax you owe. Normally, if your tax liability is less than zero, you don’t owe anything and you aren’t owed anything (unless you’ve paid too much tax during the year). However, with a refundable tax credit, you can get a tax refund even if you didn’t have any tax obligation and even if you didn’t pay any tax. Popular refundable tax credits include the Child Tax Credit, American Opportunity Tax Credit, and the Earned Income Tax Credit (EITC).
Under both tax proposals, the Child Tax Credit would increase but only $1,000 would remain refundable. The amount of the AOTCs and the EITC would not change (though some eligibility issues are affected).
11. Global Taxation. Under our current system, US companies are subject to tax on all profits, no matter where they are earned. Companies pay tax on income earned inside the US on an annual basis and they pay tax on foreign-sourced income when income is repatriated, or brought back to the US. If the company paid tax to a foreign country for that income, the company is entitled to a credit. And even though the US has been doing this for years, it’s pretty unusual. Most countries only tax income earned inside of their borders.
The Senate and House proposals would switch to a territorial system for businesses which means that U.S. companies would only pay tax on profits earned inside our borders (that would put us in line with most of the world).
12. Pass-Through Entities. When you start a business – even if you don’t do it formally through the state – you have a few choices of how to organize.
The most simple form of entity is the sole proprietorship and at tax time, for federal purposes, there’s no need to file a separate tax return: You just fill out a Schedule C. Ditto for a Single Member Limited Liability Company (SMLLC) which is disregarded for federal purposes: Again, there’s no need to file a separate tax return since you just fill out a Schedule C.
Other entities may require a separate tax return but that doesn’t mean there are two levels of tax. For federal purposes, a Limited Liability Company (LLC), other partnership, or S corporation may choose to be taxed as a pass-through entity which means that instead of paying tax at the corporate level, income is passed to the owners and taxed at individual tax rates.
Pass-through entities in the context of tax reform are tricky. Most small and medium-sized businesses in the US are either organized as a pass-through entity or as a business owner who files a Schedule C. If you reduce corporate tax rates more than you reduce individual tax rates, there’s a problem: why pay a top tax rate of 39.6% when you could be taxed at 20%? If, however, you make it more appealing to file as a business than as a person, you’re may see a flurry of folks attempting to figure out how to be in the business of just being themselves – voila, lower tax rates! There are already attempts to reduce taxes for business owners (like paying yourself less). That’s why Congress is working on anti-abuse provisions (fair warning: tax lawyers and other planners are already thinking about loopholes).
Here’s what to keep in mind: Until the ink is dry, there’s no need to rush out to change your form of business. And if you file a Schedule C, again, don’t confuse those with Schedule A deductions on the chopping block.
13. Federal Estate Tax Exemption. The federal estate tax exemption is the amount of assets that can pass to any person – related or not – at your death without being subject to federal estate tax. If your estate doesn’t come close to the exemption amount, there’s no need to even file a federal estate tax return. In 2016, just 12,411 federal estate tax returns were filed (report downloads as a PDF).
For 2017, the federal estate tax exemption is $5.49 million per person. A married couple can combine exemptions and pass $10.98 million federal estate tax-free. And with the unlimited marital deduction, when your spouse dies, he or she can leave his or her assets to you federal estate tax-free (the tax gets paid on what’s left when you die, assuming you don’t spend it all).
Under the House plan, the federal estate tax would completely disappear after 2024 while under the Senate plan, the federal estate tax would remain, but the exemption for federal estate and gift tax would double.
Hopefully, that gives you plenty to talk about at holiday parties and family dinners. If you still have questions, you can email them to me at email@example.com – I’ll try to answer as many as I can!