December 14, 2017

Planning for Tax Reform

Republicans in the House and Senate have passed tax reform bills in their respective chambers. As the bills now go to committee for reconciliation, several items are clear: first, the text of the final bill is not likely to be set until around Christmas, leaving taxpayers no time to take action ahead of the new rules for the 2017 tax year. Second, some changes to the itemization of an individual taxpayer’s deductions are on the way. Third, the legislative and budgetary environment in Washington makes it likely that, if a bill is passed, interpreting that bill’s provisions is going to be something of a guessing game– one accountant recently described to me the current state of the environment as being, “akin to the Wild West, where anything goes.”

Let’s discuss the deductions first. Schedule A itemized deductions are currently available for property tax; mortgage interest; state tax (sales and income); and a percentage of medical costs, charitable gifts, and some professional services fees. Taxpayers total their itemized deductions each year, compare them to the standard deduction, and then take the higher of the two deductions on their income tax returns. The Tax Policy Center estimates that currently, a little less than one person in three itemizes deductions, but that will change to about one in 20 under the plans proposed by the Senate and House.

The House and Senate bills reduce or eliminate the itemized deduction for state income tax and/or cap itemized property tax deductions around $10,000.  The bills also limit the itemized deduction for mortgage interest, but at different points. Taxpayers currently receive a federal income tax deduction for state income taxes in the year the taxes are paid. If you live in a state that assesses an income tax, talk with your accountant about whether you should consider making an estimated payment of your 2017 state income tax liability this month, so that you can deduct state income taxes from your federal return one last time.

Both bills include a provision almost doubling the standard deduction. This increase in the standard deduction, coupled with the new limits in itemized deductions, means that the tax impact of charitable gifts may be reduced for some taxpayers. Consider a taxpayer with no deductible medical expenses or professional services fees, $10,000 in charitable contributions, and property taxes of $10,000. If this taxpayer is married and files a joint return, her 2018 standard deduction will be $24,000, meaning she and her spouse will likely take the standard deduction rather than itemize. Under this scenario, our sample taxpayer never realizes a tax benefit for her charitable contributions.

If Congress and the President manage to pass a tax reform package as is currently being negotiated, one strategy taxpayers may want to consider is making deductible contributions to a donor-advised fund (“DAF”). A DAF is an account that allows the taxpayer to make deductible contributions one year and then wait to distribute the funds to charities over time. With this strategy, a family could make gifts to a DAF periodically, itemizing deductions in those years in order to take the deductions for the large charitable contributions, and then return to taking the standard deduction in subsequent (non-gifting) years.

Sweeping tax legislation brings with it a host of new planning-related questions. Talk with your CPA and financial team about how this legislation may impact you as 2017 draws to a close.

As the calendar turns to 2018, there is another thing to consider. Substantial tax legislation is often followed up with a subsequent bill (generally called a Tax Technical Corrections Act). The Corrections Acts address issues that have come up with the implementation of the new tax rules. Republicans are rushing to pass their tax legislation in 2017 under reconciliation rules (which only require a majority vote), but any technical corrections legislation (in 2018) would need to be passed under standard voting requirements, which may prove tricky for Republicans to pull off. In the case of 2017 tax legislation, the first draft may very well be the final draft.

Taxpayers will likely find further frustration if they turn to the IRS for assistance in interpreting the new rules. From 2010 to 2016, the agency saw a 17 percent cut in funding and a 14 percent reduction in staff, resulting in fewer audits and longer wait times for tax regulations, technical advice memoranda, and private letter rulings. President Trump has proposed cutting an additional 14 percent from the IRS budget in 2018.

What do you get when you draft massive tax legislation at the eleventh hour, with your hands tied on the possibility of revising the bill, all while cutting the ability to enforce the provisions? Busy accountants and lawyers.