There were many tax law changes adopted in the Tax Cuts and Jobs Act of 2017 (The Act) and while most of these changes are directed at individual and corporate taxpayers, investment companies holding portfolio companies will feel the impact as well as the investors receiving pass-through income from them. The impact of the Act to an investor will depend on his or her personal tax situation because The Act, as you will see below, both benefits and hinders with respect to different areas of the tax code.
The Good News
Most people want to hear the good news first, so let’s discuss the positives about The Act, tax rates. The highest corporate and individual tax rates have both decreased. The top corporate tax rate was dropped to 21% from 35% and the top individual tax rate was dropped to 37% from 39.6%. The corporate tax rate drop is a big win for portfolio companies that hold corporate stock. The Act also eliminates the corporate Alternative Minimum Tax (AMT) and increases the AMT exemption for individuals, and the capital gain tax rates remain unchanged.
Another positive for individuals is that The Act eliminates the phase-out of an individual’s itemized deductions, also known as the Pease limitation, which previously would phase-out itemized deductions as much as 80% excluding investment interest. Also, in honor of philanthropy, The Act increased the amount of charitable donations an individual can deduct in a taxable year with the limitation being based on 60% of adjusted gross income vs. 50%.
There was no tax simplification with the adoption of the pass-through deduction in The Act. Businesses that are structured as pass-through entities, such as S-Corporations or Limited Liability Companies or self-employed individuals, may be eligible for a 20% deduction of Qualified Business Income. Certain types of service related businesses such as financial services, brokerage, accounting, legal and health, are not eligible for the deduction. This new tax law has left taxpayers and advisors with more questions than the text of the law itself, so we can expect to see many regulations and rulings forthcoming to clarify who is and who is not eligible for the deduction and how to calculate it.
If you are in the mood to spend, The Act has created incentives to do so. The Section 179 expensing of personal property acquisitions such as equipment, furniture and fixtures is increased to $1,000,000 per year. Also, bonus depreciation on personal property acquisitions increased to 100% from 50% and now applies to new and used property purchases where the contract entered into, the purchase and the placed-in-service date took place after September 27, 2017. This is a big win for portfolio company holdings that are capital intensive.
The Bad News
One change affecting most businesses is that the 50% deduction for entertainment expenses was repealed, but the 50% deduction for business meals was preserved. Also, the tax deferral technique known as a like-kind exchange for personal property was also repealed. This means you can no longer trade in your plane, train or automobile and defer the tax on the sale on those types of assets.
On the individual tax side, miscellaneous itemized deductions (subject to the 2% of adjusted gross income limitation) such as investment expenses, broker fees, tax prep fees and unreimbursed business expenses were repealed. This means that management and professional fees passed through by investment funds to their investors will no longer be deductible.
The deduction of property/state/local/sales tax deduction will be limited to $10,000 per year for all filers. The interest expense on home equity loans will no longer be deductible, and The Act limits the mortgage interest deduction to interest on $750,000 of acquisition indebtedness, previously $1,000,000. There are, however, some grandfathering rules on loans that existed at the end of 2017.
The new tax law changes the holding period requirement long term capital gain for carried interests. Investment managers in an investment partnership will generate long term capital gains to the extent the capital assets from which the capital gain is derived are held for more than three years. as opposed to more than one year, under prior law. Carried interests that are not attributable to “three-year property” generally will be taxable as short-term capital gain for federal income tax purposes at the applicable ordinary income rate.
We Can Help
As your tax rates go down, some deductions will go up and some deductions will go down. With so many law changes and the complexities of them in The Act, having a projection of the effects of the tax law changes on your taxable income by your Elliott Davis tax advisor may help you sleep better at night.