As tax professionals, one of the questions we've been hearing a lot lately is, 'How will the federal tax law changes for 2018 (Tax Cuts and Jobs Act of 2017) affect my state business and personal taxes?'.
Most of us are familiar with the changes the Tax Cuts and Jobs Act of 2017 will have on Federal returns, while the state ramifications are a bit confusing still. Here is an overview of the main points on both business and personal returns.
C-Corporations
The Tax Cuts and Jobs Act of 2017 changed the Corporate tax rate to 21% across the board. This is a decrease for most businesses as pre-TCJA rates were based on taxable income. Businesses with taxable income of 0 to $50,000 paid 15% tax (rates actually went up for these corporations!), $50,001 to $75,000 taxable income paid 25%, $75,001 to 10 million taxable income paid 34% and over 10 million taxable income paid 35%. All personal service corporations also paid a flat 35% tax rate.
Another change for corporations from the TCJA is a reduced deduction of dividends received from other corporations. Before TCJA, if a corporation owned stock in another corporation, they could deduct 80% of the dividends received from that corporation if they owned at least 20% of it. If they owned under 20%, the deduction rate was 70%. Pretty good deal, right? Now under the TCJA the dividend deduction rates are 65% (vs 80%) and 50% (vs 70%).
One last notable change for C-Corps is the repeal of Alternative Minimum Tax (AMT), starting in 2018, which before TCJA was a 20% tax rate. Under the previous law, an AMT credit was allowed for corporations that paid AMT in past years. The new law does allow corporations to fully use their credit carryover from AMT in years 2018 through 2021 and then is no longer available.
Pass-Through entities (S-Corps, Partnerships, Sole Proprietorships, and LLCs)
For business owners of pass-through entities (business income passes through to the owner’s tax return), there is the possible deduction of up to 20% of business income, under the 199A deduction. Before TCJA, net taxable income for pass-through businesses flowed through to the owner’s return. The income was then taxed at their standard tax rate on their personal return with no special consideration.
Beginning in 2018, there is a new deduction for these business owners based on their Qualified Business Income (QBI) associated with a US-based business. Income from ownership in a foreign company does not qualify for the deduction. The business income items that make up the QBI include income, gain, deduction, and loss from a qualified trade or business. It does not include certain investment-related income items, compensation to the owner for service to the business, or guaranteed payments to a partners for service in a partnership or LLC member treated as a partner.
The 199A (QBI) deduction doesn’t reduce the pass-through owner’s AGI, it reduces their taxable income. So it’s similar to an allowable itemized deduction. The IRS shows the calculation of the deduction as the lesser of the following:
- 20 percent of the taxpayer’s QBI, plus 20 percent of the taxpayer’s qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income or
- 20 percent of the taxpayer’s taxable income minus net capital gains.
However, there are income limitations to this deduction. For business owners that file as Single with an income above $157,500 or for Married Filing Jointly owners whose income is above $315,000, there are extra requirements that can get pretty complicated. If the income is under these thresholds, the owner should qualify for the full 20% deduction. But for higher income owners the deduction may be limited. These limits are based on the W-2 wages paid by the company, the unadjusted basis of certain property used by the company, and whether the business is a service based business.
These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500. If the income is above those higher thresholds, the deduction is completely phased out. The threshold amounts and phase-in ranges are for tax-year 2018 and will be adjusted for inflation in years to come.
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The other limitation of the 199A deduction (as noted above) is regarding certain service-based businesses (SSTB). These SSTBs are not eligible to take advantage of the 199A deduction at higher incomes.
Service-based business include:
- Traditional service professions such as doctors, attorneys, accountants, actuaries, and consultants
- Performing artists who perform on stage or studio
- Paid athletes
- Anyone who works in the financial services or brokerage industry
- Any trade or business where the principal asset is the reputation or skill of the owner (excluding engineers and architects)
These specified service businesses are excluded only if their income is above the higher income limiters of $157,500 for single filers and $315,000 for married filing jointly filers. There is no phase-out for this group; if they are over the income threshold, they aren't eligible for the deduction. For more specific information on the 199A deduction, see our blog that digs into the 199A deduction here.
Other tax law changes affecting all businesses for 2018 and beyond
Beginning in 2018, corporate and pass-through business entities will be limited to the amount of interest they are allowed to deduct as a business expense. The TCJA limits interest expense deducted to 30% of “adjusted taxable income.” Before TCJA there was no limit.
The TCJA of 2017 also rejects all entertainment expenses and sets more strict rules on meal expenses. Meals while traveling are okay, but on-premise cafeteria meals provided by the employer will be phased down to 50% deduction, and will not be deductible after 2025. There is one bright spot in this…employee parties are still 100% deductible!
There are also some smaller changes that won’t affect as many businesses that are still important to be aware of.
Changes for Federal returns on the personal side:
- Standard deductions have increased. For 2018 the standard deductions are $24,000 for Married Filing Jointly, $18,000 for Head of Household and $12,000 for single filers. These are nearly doubled from the 2017 amounts of $12,700, $9,350 and $6,350 respectively.
- Personal exemptions have been eliminated.
- Most individual tax rates have been lowered. However, the tax brackets were modified which lands some higher-income taxpayers in a higher percentage rate bracket than they were under previously.
- A number of itemized deductions have been modified or eliminated:
- Deductible state and local taxes (SALT) are limited to $10,000 ($5,000 for MFS) which includes income, real estate, and sales taxes.
- The home mortgage interest deduction cap for principal value is decreased from $1 million to $750,000 for loans after 12/15/17.
- Home-equity loan interest is now only deductible if the loan was used to improve a home. Pre-TCJA law allowed interest on home-equity loans up to $100,000 to be deducted no matter how the money was spent.
- The AGI cap for contributions to public charities increased to 60%.
- The deduction for miscellaneous expenses subject to the 2% floor is gone. These expenses included tax fees, safe deposit boxes, unreimbursed employee expenses, etc.
- For 2017 and 2018 the AGI threshold for deducting medical expenses is lowered to 7.5%. For tax year 2019 it will go back up to 10%.
- The child tax credit increased from $1,000 to $2,000 and raised the phaseout for it. The first $1,400 will be refundable.
- A new credit was added for other dependents
- Most of the income tax changes will be temporary, expiring December 31, 2025.
How will the Tax Cuts and Jobs Act of 2017 affect Corporations and Pass-Through entities at the state level?
For C-Corporations, the lowered Federal tax rate won’t have any significant impact at the state level. Each state has it’s own Corporate tax rate. Except for South Dakota and Wyoming, that have no corporate tax, and Nevada, Ohio, Texas and Washington which levy a Gross Receipts tax rather than an income tax. Some states did pass legislation to lower their state rates, and some raised them or made other changes. States typically use the corporation's profits and net worth to calculate taxable income, then tax it at their own rate. So generally, the Federal tax rate change won’t have any effect on the state returns for C-Corporations.
For pass-through entities, it’s essentially the same scenario for the state returns as it is for the Corporations. The minimum tax to these entities (Partnership and S-Corp specifically) is often based on the profits of the company, or a combination of property, payroll and sales receipts. The main change for pass-through entities will be the 199A deduction which will affect the owner’s federal return.
How will the 199A deduction impact the personal return of a Pass-Through entity's owner?
Each state has a starting point for individual tax returns that originates from a line item on the individual’s federal return. For most states, federal adjusted gross income is the line item that is used to start their state return. In states with this starting point, the 199A deduction will have no effect on the individual return for that owner. This is because the 199A deduction on the federal return is after federal adjusted gross income, and therefore reduces AGI along with the standard or itemized deductions. Unless the state adopted a similar deduction to the 199A deduction, which only a few states did, there would be no benefit from the 199A deduction.
Two states that did specifically pass a bill to incorporate the 199A deduction are Alabama and Mississippi. Other states have updated their laws to conform to the new tax code. If the state return starts with federal AGI, the 199A deduction is dropped at the state level unless legislation was passed to incorporate it. Iowa is one state that passed it’s own legislation to incorporate the 199A deduction and lower tax rates as well.
Another less common starting point for individual state returns is taxable income from the federal return. Generally, fewer states start at this point. If you are filing with a state that uses this starting point, it will include the 199A deduction. Which means your starting income will be reduced already unless that state passed legislation to “decouple” from this deduction by requiring an add-in on the state return. Oregon, New Jersey, and Hawaii have all chosen to “decouple” and not allow the 199A deduction on the state returns.
To make a long story short, the business tax rates and deductions passed with the Tax Cuts and Jobs Act of 2017 will need to be looked at on a case by case basis. Doing this will accurately determine the impact that the new laws will have, both at the Federal and State levels.
What effect with the TCJA changes have on personal return items?
Again, this question does not have a straightforward answer. It's easier to spot changes on each individual or joint return. For federal returns, some filers will benefit from a higher standard deduction, and perhaps the personal exemption suspension won’t hurt them. While other filers with larger families or large amounts of state and local taxes will likely find themselves with a higher tax bill due to the changes. Even with a more substantial Child Tax Credit and the added Other Dependents credit, the lack of personal exemptions and modifications to itemized deductions may hurt many taxpayers.
How these changes flow through to individual state returns is going to depend on how each state responded to the reforms that TCJA enacted. Even if states conformed through rolling conformity or fixed date conformity, they might have passed legislation to exclude certain portions of the TCJA changes. For example, Minnesota responded by changing the starting point of the state return from federal taxable income to federal adjusted gross income (no 199A deduction for MN filers). Then Minnesota lets you choose between the standard deduction or itemizing, even if you didn’t do so on the federal return. Minnesota also allows personal and dependent exemptions, up to a certain income amount, and at higher incomes, they will go through a phase-out.
In this example, it may be more work for those who weren’t able to itemize on the federal return, but it may be well worth it to do so on the state return. Some states have followed a plan similar to Minnesota’s, whereas other states have followed the TCJA changes and done away with personal and dependent exemptions. The best way to find out what is happening in your state is to look up the information online. An alternative is to wait until the state software is available and start inputting your numbers!
Whether the Tax Cuts and Jobs Act of 2017 ends up benefitting or troubling individuals and businesses, we at least know one thing, it’s not permanent. Most of it is set to expire at the end of 2025, but we know other changes in the tax code could happen in the interim. If you have more questions about your individual tax return, be sure to ask your tax preparer for clarification.
