No Deduction For Entertainment Expenses In 2019. Ouch!!

There is a little known change that was included in tax reform that will potentially have a big impact on business owners.  The new tax laws that went into effect on January 1, 2018 placed stricter limits on the ability to deduct expenses associated with entertainment and business meals.  Many of the entertainment expenses that businesses were able to deduct in 2017 will no longer we allowed in 2018 and beyond.  A big ouch for business owners that spend a lot of money entertaining clients and prospects. 

A Quick Breakdown Of The Changes

new tax rules for entertainment expenses

No Deduction in 2019

Prior to 2018, if the business spent money to take a client out to a baseball game, meet a client for 18 holes of golf,  or to host a client event,  the business would be able to take a deduction equal to 50% of the total cost associated with the entertainment expense.  Starting in 2018, you get ZERO.  There is no deduction for those expenses. 

The new law specifically states that there is no deduction for: 

• Any activity generally considered to be entertainment, amusement, or recreation

• Membership dues to any club organization for recreation or social purpose

• A facility, or portion thereof, used in connection with the above items

This will inevitably cause business owners to ask their accountant: “If I spend the same amount on entertainment expenses in 2018 as I did in 2017, how much are the new tax rules going to cost me tax wise?” 

Impact On Sales Professionals

If you are in sales and big part of your job is entertaining prospects in hopes of winning their business, if your company can no longer deduct those expenses, are you going to find out at some point this year that the company is going to dramatic limit the resources available to entertain clients?  If they end up limiting these resources, how are you supposed to hit your sales numbers and how does that change the landscape of how you solicit clients? 

Impact On The Entertainment Industry

This has to be bad news for golf courses, casinos, theaters, and sports arena.  As the business owner, if you were paying $15,000 per year for your membership to the local country club and you justified spending that amount because you knew that you could take a tax deduction for $7,500, now what?  Now that you can’t deduct any of it, you may decide to cancel your membership or seek out a cheaper alternative. 

Impact On Charitable Organizations

How do most charities raise money?  Events.   As you may have noticed in the chart, in 2017 tickets to a qualified charitable event were 100% deductible.  In 2018, it goes from 100% deductible to Zero!!  It’s bad enough that the regular entertainment expenses went from 50% to zero but going from 100% to zero hurts so much more.  Also charitable events usually have high price tags because they have to cover the cost of event and raise money for the charity.  In 2018, it will be interesting to see how charitable organizations get over this hurdle. It may have to disclose right on the registration form for the event that the ticket cost is $500 but $200 of that amount is the cost of the event (non-deductible) and $300 is the charitable contribution. 

Exceptions To The New Rules

There are some unique exceptions to the new rules.  Many business owners will not find any help within these exceptions but here they are: 

• Entertainment, amusement, and recreation expenses you treat as compensation to your employees in their wages (In other words, the cost ends up in your employee’s W2)

• Expenses for recreation, social, or similar activities, including facilities, primarily for employees, and it can’t be highly compensation employees (“HCE”). In 2018 an HCE employee is an employee that makes more than $120,000 or is a 5%+ owners of the company.

• Expenses for entertainment goods, services, and facilities that you sell to customers

What’s The Deal With Meals?

Prior to 2018, employers could deduct 50% of expenses for business-related meals while traveling.  Also meals provided to an employee for the convenience of the employer on the employer’s business premises were 100% deductible by the employer and tax-free to the recipient employee.

Starting in 2018, meal expenses incurred while traveling on business remain 50% deductible to the business. However, meals provided via an on-premises cafeteria or otherwise on the employers premise for the convenience of the employer will now be limited to a 50% deduction.

There is also a large debate going on between tax professional as to which meals or drinks may fall into the “entertainment” category and will lose their deduction entirely.

Impact On Business

This is just one of the many “small changes” that was made to the new tax laws that will have a big impact on many businesses.   It may very well change the way that businesses spend money to attract new clients.  This in turn will most likely lead to unintended negative consequences for organizations that operate in the entertainment, catering, and charitable sectors of the U.S. economy.

Disclosure: For education purposes only. Please seek tax advice from your tax professional

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Business Owners: Strategies To Reduce Your Taxable Income To Qualify For The New 20% Qualified Business Income Deduction

Now that small business owners have the 20% deduction available for their pass-through income in 2018, as a business owner, you will need to begin to position your business to take full advantage of the new tax deduction. However, the Qualified Business Income ("QBI") deduction has taxable income thresholds. Once the owner's personal taxable income begins to exceed specific dollar amounts, the 20% deduction with either phase out or it will trigger an alternative calculation that could lower the deduction.

First: Understand The 20% Deduction

If you are not already familiar with how the new 20% deduction works, I encourage you to read our article:"How Pass-Through Income Will Be Taxes In 2018 For Small Business Owners"If you are already familiar with how the Qualified Business Income deduction works, please continue reading.

The Taxable Income Thresholds

Regardless of whether you are considered a “services business” or “non-services business” under the new tax law, you will need to be aware of the following income thresholds:

Individual: $157,500

Married: $315,000

These threshold amounts are based on the “total taxable income” listed on the tax return of the business owner. Not “AGI” and not just the pass-through income from the business. Total taxable income. For example, if I make $100,000 in net profit from my business and my wife makes $400,000 in W-2 income, our total taxable income on our married filing joint tax return is going to be way over the $315,000 threshold. So do we completely lose the 20% deduction on the $100,000 in pass-through income from the business? Maybe not!!

The Safe Zone

For many business owners, to maximize the new 20% deduction, they will do everything that they can to keep their total taxable income below the thresholds. This is what I call the “safe zone”. If you keep your total taxable income below these thresholds, you will be allowed to take your total qualified business income, multiply it by 20%, and you’re done. Once you get above these thresholds, the 20% deduction will either begin to phase out or it will trigger the alternative 50% of W-2 income calculation which may reduce the deduction.  The phase out ranges are listed below:

Inidividuals: $157,500 to $207,500

Married: $315,000 to $415,000

As you get closer to the top of the range the deduction begins to completely phase out for “services businesses” and for “non-services business” the “lesser of 20% of QBI or 50% of wages paid to employees” is fully phased in.

What Reduces "Total Taxable Income"?

There are four main tools that business owners can use to reduce their total taxable income:

• Standard Deduction or Itemized Deductions

• Self-Employment Tax

• Retirement Plan Contributions

• Timing Expenses

Standard & Itemized Deductions

Since tax reform eliminated many of the popular tax deductions that business owners have traditionally used to reduce their taxable income, for the first time in 2018, a larger percentage of business owners will elect taking the standard deduction instead of itemizing. You do not need to itemize to capture the 20% deduction for your qualified business income. This will allow business owners to take the higher standard deduction and still capture the 20% deduction on their pass-through income. Whether you take the standard deduction or continue to itemize, those deductions will reduce your taxable income for purposes of the QBI income thresholds.

Example: You are a business owner, you are married, and your only source of income is $335,000 from your single member LLC. At first look, it would seem that your total income is above the $315,000 threshold and you are subject to the phase out calculation. However, if you elect the standard deduction for a married couple filing joint, that will reduce your $335,000 in gross income by the $24,000 standard deduction which brings your total taxable income down to $311,000. Landing you below the threshold and making you eligible for the full 20% deduction on your qualified business income.

The point of this exercise is for business owners to understand that if your gross income is close to the beginning of the phase out threshold, somewhere within the phase out range, or even above the phase out range, there may be some relief in the form of the standard deduction or your itemized deductions.

Self-Employment Tax

Depending on how your business is incorporated, you may be able to deduct half of the self-employment tax that you pay on your pass-through income. Sole proprietors, LLCs, and partnership would be eligible for this deduction. Owners of S-corps receive W2 wages to satisfy the reasonable compensation requirement and receive pass-through income that is not subject to self-employment tax. So this deduction is not available for S-corps.

The self-employment tax deduction is an “above the line” deduction which means that you do not need to itemize to capture the deduction. The deduction is listed on the first page of your 1040 and it reduces your AGI.

Example: You are a partner at a law firm, not married, the entity is taxed as a partnership, and your gross income is $200,000. Like the previous example, it looks like your income is way over the $157,500 threshold for a single tax filer. But you have yet to factor in your tax deductions. For simplicity, let’s assume you take the standard deduction:

Total Pass-Through Income: $200,000

Less Standard Deduction: ($12,000)

Less 50% Self-Employ Tax: ($15,000) $200,000 x 7.5% = $15,000

Total Taxable Income: $173,000

While you total taxable income did not get you below the $157,500 threshold, you are now only mid-way through the phase out range so you will capture a portion of the 20% deduction on your pass-through income.

Retirement Plans – "The Golden Goose"

Retirement plans will be the undisputed Golden Goose for purposes of reducing your taxable income for purposes of the qualified business income deduction. Take the example that we just went through with the attorney in the previous section. Now, let’s assume that same attorney maxes out their pre-tax employee deferrals in the company’s 401(k) plan. The limit in 2018 for employees under the age of 50 is $18,500.

Total Pass-Through Income: $200,000

Less Standard Deduction: ($12,000)

Less 50% Self-Employ Tax: ($15,000)

Pre-Tax 401(k) Contribution: ($18,500)

Total Taxable Income: $154,500

Jackpot!! That attorney has now reduced their taxable income below the $157,500 QBI threshold and they will be eligible to take the full 20% deduction against their pass-through income.

Retirement plan contributions are going to be looked at in a new light starting in 2018. Not only are you reducing your tax liability by shelter your income from taxation but now, under the new rules, you are simultaneously increasing your QBI deduction amount.

When tax reform was in the making there were rumors that Congress may drastically reduce the contribution limits to retirement plans. Thankfully this did not happen. Long live the goose!!

Start Planning Now

Knowing that this Golden Goose exists, business owners will need to ask themselves the following questions:

• How much should I plan on contributing to my retirement accounts this year?

• Is the company sponsoring the right type of retirement plan?

• Should we be making changes to the plan design of our 401(k) plan?

• How much will the employer contribution amount to the employees increase if we try to max out the pre-tax contributions for the owners?

Business owners are going to need to engage investment firms and TPA firms that specialize in employer sponsored retirement plan. Up until now, sponsoring a Simple IRA, SEP IRA, or 401(K), as a way to defer some income from taxation has worked but tax reform will require a deeper dive into your retirement plan. The golden question:

“Is the type of retirement plan that I’m currently sponsoring through my company the right plan that will allow me to maximize my tax deductions under the new tax laws taking into account contribution limits, admin fees, and employer contributions to the employees.”

If you are not familiar with all of the different retirement plans that are available for small businesses, please read our article “Comparing Different Types Of Employer Sponsored Plans”.

DB / DC Combo Plans Take Center Stage

While DB/DC Combo plans have been around for a number of years, you will start to hear more about them beginning in 2018. A DB/DC Combo plan is a combination of a Defined Benefit Plan (Pension Plan) and a Defined Contribution Plan (401k Plan). While pension plans are usually only associated with state and government employers or large companies, small companies are eligible to sponsor pension plans as well. Why is this important? These plans will allow small business owners that have total taxable income well over the QBI thresholds to still qualify for the 20% deduction.

While defined contribution plans limit an owner’s aggregate pre-tax contribution to $55,000 per year in 2018 ($61,000 for owners age 50+), DB/DC Combo plans allow business owners to make annual pre-tax contributions ranging from $60,000 – $300,000 per year. Yes, per year!!

Example: A married business owner makes $600,000 per year and has less than 5 full time employees. Depending on their age, that business owner may be able to implement a DB/DC Combo plan prior to December 31, 2018, make a pre-tax contribution to the plan of $300,000, and reduce their total taxable income below the $315,000 QBI threshold.

Key items to make these plans work:

• You need to have the cash to make the larger contributions each year

• These DB/DC plan needs to stay in existence for at least 3 years

• This plan design usually works for smaller employers (less than 10 employees)

Shelter Your Spouse's W-2 Income

It's not uncommon for a business owner to have a spouse that earns W-2 wages from employment outside of the family business. Remember, the QBI thresholds are based on total taxable income on the joint tax return. If you think you are going to be close to the phase out threshold, you may want to encourage your spouse to start putting as much as they possibly can pre-tax into their employer's retirement plan. Unlike self-employment income, W-2 income is what it is. Whatever the number is on the W-2 form at the end of the year is what you have to report as income. By contrast, business owners can increase expenses in a given year, delay bonuses into the next tax year, and deploy other income/expense maneuvers to play with the amount of taxable income that they are showing for a given tax year.

Timing Expenses

One of the last tools that small business owners can use to reduce their taxable income is escalating expense. Now, it would be foolish for businesses to just start spending money for the sole purpose of reducing income. However, if you are a dental practice and you were planning on purchasing some new equipment in 2018 and purchasing a software system in 2019, depending on where your total taxable income falls, you may have a tax incentive to purchase both the equipment and the software system all in 2018. As you get toward the end of the tax year, it might be worth making that extra call to your accountant, before spending money on those big ticket items. The timing of those purchases could have big impact on your QBI deduction amount.

Disclosure: The information in this article is for educational purposes. For tax advice, please consult your tax advisor.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Rental Income Will Be Taxed In Years 2019+

Tax reform will change the way rental income is taxed to landlords beginning in 2018. Under current law, rental income is classified as "passive income" and that income simply passes through to the owner's personal tax return and they pay ordinary income tax on it. Beginning in 2018, rental income will be eligible to receive the same preferential tax treatment as the "qualified business income" (QBI) for small business owners.

20% Deduction

Starting in 2018, taxpayers with qualified business income (including rental income), may be eligible to take a tax deduction up to 20% of their QBI. Determining whether or not you will be eligible to capture the full 20% deduction on your rental income will be based on your total taxable income for year. The taxable income thresholds are as follows:Single filers: $157,500Married filing joint: $315,000"Total taxable income" is not your AGI (adjusted gross income) and it's not just income from your real estate business or self-employment activities. It's your total taxable income less some deductions. The IRS has yet to provide us with full guidance on the definition of "total taxable income". For example, let's assume you have three rental properties owned by an LLC and you net $50,000 in income from the LLC each year. But your wife is a lawyer that makes $350,000 per year. Your total taxable income for the year would be $400,000 landing you above the $315,000 threshold.

Below The Income Threshold

If your total taxable income is below the income thresholds listed above, the calculation is very easy. Take your total QBI and multiply it by 20% and that's your tax deduction.

Above The Income Threshold

If your total taxable income is above the thresholds, the calculation gets more complex. If you exceed the income thresholds, your deduction is the LESSER of:

1. 20% of QBI

1. The GREATER OF:

• 50% of W-2 wages paid to employees

• 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis

The best way to explain the calculation is by using an example. Assume the following:

• I bought a commercial building 3 years ago for $1,000,000

• I have already captured $100,000 in depreciation on the building

• After expenses, I net $150,000 in income each year

• The LLC that owns the property has no employees

• I'm married

• I own a separate small business that makes $400,000 in income

Since I'm over the $315,000 total taxable income threshold for a married couple filing joint, I will calculate my deduction as follows:The LESSER of:

1. 20% of QBI = $30,000 ($150,000 x 20%)

1. The GREATER of:

• 50% of W-2 wage paid to employees = $0 (no employees)

• 25% of W-2 wages page to employees plus 2.5% of unadjusted basis

(25% of wages = $0) + (2.5% of unadjusted basis = $25,000) = $25KIn this example, my deduction would be limited to $25,000. Here are a few special notes about the calculation listed above. In the 11th hour, Congress added the "2.5% of unadjusted basis" to the calculation. Without it, it would have left most landlords with a $0 deduction. Why? Real estate owners typically do not have W-2 employees, so 50% of W-2 wages would equal $0. Some larger real estate investors have "property management companies" but they are usually set up as a separate entity. In which case, the W-2 income of the property management company would not be included in the calculation for the QBI deduction. If you are someone who owns a property or properties and is need of a Property management company to help you with organizing and operating your property, then doing research in your general area to find a real estate company that can help you with that is important.Another special note, 2.5% is based on an unadjusted basis and it's not reduced by depreciation. However, the tangible property has to be subject to depreciation on the last day of the year to be eligible for the deduction. Meaning, even though the 2.5% is not reduced for the amount of depreciation already taken on the property, the property must still be in the "depreciation period" on the last day of the year to be eligible for the QBI deduction.Tony Nitti, a writer for Forbes, also makes the following key points:

• The depreciable period starts on the date the property is placed in service and ends on the LATER of:

- 10 years, or- The last day of the last full year in the asset's "regular" (not ADS) depreciation periodMeaning, if you purchase a non-residential rental building that is depreciated over 39 years, the owner can continue to capture the depreciation on the building but that will not impact the 2.5% unadjusted basis number for the full 39 years of the depreciation period.

• Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count toward the basis.

• Shareholders or partners may only take into consideration for purposes of applying the limitation 2.5% his or her allocable share of the basis of the property. So if the total basis of commercial property is $1,000,000 and you are a 20% owner, you basis limitation is $1,000,000 x 20% x 2.5% = $5,000

Phase-In Of The Threshold

The questions I usually get next is: "If I'm married and our total taxable income is $320,000 which is only $5,000 over the threshold, do I automatically have to use the more complex calculation?" The special calculation "phases in" over the following total taxable income thresholds:Single filers: $157,500 - $207,500Married filing joint: $315,000 - $415,000I won't get into the special phase-in calculation because it's more complex than the special "above the income threshold" calculation that we already walked through but just know that it will be a blend of the straight 20% deduction and the W-2 & 2.5% adjusted basis calculation.

Qualified Trade or Business Requirement

In August 2018, the IRS came out with further clarification of how the QBI deduction would apply to real estate. In order to qualify for the QBI deduction for real estate income, your real estate holdings have to qualify as a "trade or business". The definition of a trade or business for QBI purposes deviates slightly from the traditional IRS definition. There is a safe harbor that states if you spend more than 250 hours a year working on that business it will qualify for the deduction.There are a few items to consider in the 250 hour calculation. So called "drive bys" where the owner is spending time driving by their properties to check on them does not count toward the 250 hours. If you have a property management company, the hours that they spend managing your propoerty can be credited toward your 250 hour requirement. However, the property management company has to provide you with proper documentation to qualify for those credited hours.

Consult Your Accountant

I'm a Certified Financial Planner®, not an accountant. I wrote this article to give real estate investors a broad view of what tax reform may have instore for them in 2018. If you own rental property, you should be actively consulting with our accountant through the year. As the IRS continues to release guidance regarding the QBI deduction throughout 2018, you will want to make sure that your real estate holdings are positioned properly to take full advantage of the new tax rules.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What Does Tax Reform Mean For The Markets In 2018?

2017 ended up being a huge year for the U.S. stock market.  The rally in the stock market was unmistakably driven by the anticipated passing of tax reform and Congress delivered. However, the sheer magnitude of the stock market rally has presented investors with a moment of pause and a lot of unanswered questions as we enter into the first quarter of 2018. The two main questions being:

• What does tax reform mean for the markets in 2018?

• We are now in the second longest economic expansion of ALL TIME!!! I know what goes up, eventually comes down. Are we overdue for a major correction in the stock market?

Without a crystal ball, no one knows for sure. However, the purpose of this article is to identify indicators in the economy and the financial markets that may help us gauge the direction of the U.S. economy and equity markets as we progress through 2018.

Tax Reform: Uncharted Waters

While tax reform is a welcome friend for corporate America, we have to acknowledge that this also puts us in uncharted waters. Looking back, there has never been a time in history where the U.S. has injected fiscal stimulus (tax reform) into an economy that is already healthy. The last major tax reform was in the early 1980’s when the U.S. economy was trying to dig itself out of the long 1970’s recession.

When the economy is in a recession, the U.S. can either inject fiscal stimulus or monetary stimulus to get the economy growing again. The U.S. used monetary stimulus to dig us out of the Great Recession of 2008 – 2009. They lowered interest rates to basically 0%, pumped cash into the economy in the form of bond buying, and provided a financial back stop for the U.S. banking system.

These economic stimulus tools are similar to the concept of giving a patient in a hospital a shot of adrenaline. If a patient is flat lining, it provides that patient with a huge surge of energy. The patient’s body goes from 0% to 60%+ in under a minute. So what happens when you give someone who is completely healthy a shot of adrenaline? Do they go from 100% to 110%? My point is a healthy patient does not go from 100% to 160%. Both patients get a boost but the boost to the healthy patient is much lower as a percentage of where they started.

While we have never given the U.S. economy an adrenaline shot after a long economic expansion, I think it’s reasonable to apply the same general concept as our two hospital patients. Tax reform may very well lead to another year of positive returns for the stock market in 2018 but I think it’s very important for investors to set a reasonable expectation of return for the U.S. equity markets given the fact that we are injecting growth into an economy that is already at “full employment”.

Not Enough Workers

One of the greatest challenges that the U.S. economy may face in 2018 is a shortage of qualified workers. Prior to tax reform being passed, companies both large and small, have had plenty of job openings but have not been able to find the employees with the skills necessary to fill those positions.

For example, if Apple had 1000 job openings in November 2017 just to meet the current demand for their goods and services but in 2018, due to tax reform, consumers have more money to spend, and the demand for Apple products increases further, Apple may need to find another 2000 employee to meet the increase in demand. They are having trouble now finding the 1000 employees to meet their current demand, how are they going to find another 2000 quick enough in 2018 to meet the increase in demand? If they can’t make the phones, they can’t sell the phones. Fewer sales equals less revenue, which equals less net profit, which may lead to a lower appreciation rate of the stock price. For disclosure purposes, I’m not picking on Apple. I’m just highlighting an issue that may be common among the companies that make up the S&P 500 Index if tax reform leads to a spike in demand in 2018. If Wall Street is expecting accelerated earnings, how are the companies expected to deliver those enhanced earnings without the employees that they need to increase supply?

The unemployment rate in the U.S. is currently 4.1%. You have to go all the way back to the late 1960’s to find an employment rate below 4%. So we are essentially at “full employment”.

Rising Wages

The blue line in the chart above is also very important. The blue line represents wage growth. This answers the question: "Are people making more for doing the same amount of work?" If you look back historically on the chart, when the unemployment rate was falling, typically wage growth was increasing. It makes sense. When the economy is good and the job market is healthy, companies have to pay their employees more to keep them. Otherwise they will go work for a competitor, who has 10 job openings, and they get paid more. Wage growth is good for employees but it's bad for companies. For companies, employee wages are usually their largest expense. If you increase wages, you are increasing expenses, which decreases profits. Lower profits typically results in lower stock prices. Companies in 2017 had the luxury of strong demand but limited wage growth. My guess is you will begin to see meaningful wage growth in 2018 as companies see an increase in demand as a result of tax reform and end up having to raise wages to retain and attract employees. This is just another reason why 2018 may be a good year for the stock market but not a great one.

What Fuels GDP Growth?

Gross Domestic Product ("GDP") is the economic indicator that is used to measure how much the U.S. economy produces in a year. It's how we gauge whether our economy is growing or contracting. Since March 2009, the GDP growth rate has averaged about 2.2% per year. This is subpar by historic standards. In most economic expansions, GDP is growing at an annual rate of 4%+.

Before we get into what pieces of tax reform may help to increase the GDP growth rate, let us first look at what GDP is made of. Our GDP is comprised of 5 categories (for my fellow econ nerds that assign 4 categories to GDP, we split capital spending into two separate categories):

• Consumption or "Consumer Spending" 69.1%

• Government Spending (includes defense) 17.3%

• Investment (ex-housing) – "Business Spending 12.7%

• Housing 3.8%

• Net Exports -2.9%

Consumer Spending (+)

Consumer spending which makes up 69.1% of our GDP should increase as a result of tax reform in 2018. In general, if people have more discretionary income, they will spend all or a portion of it. Tax reform will lower the tax bill, for not all, but many U.S. households, increasing their disposable income.  Also, if we see an increase in wage growth in 2018, people will be taking home more in their paychecks, allowing them to spend more.

Dr James Kelly, the chief economist of JP Morgan, made a very interesting observation about the evolution of the tax bill. When the tax bills were in their proposed state, one for the Senate and a separate bill for the House, each bill to stay under the $1.5 Trillion 10 year debt cap reduced taxes by about $150 Billion dollars per year. 50% of the annual tax reduction was going to businesses with the other 50% going to individual tax payers.

In order to get the bill passed before the end of the year, Congress was forced to shift a larger proportion of the $150 billion in tax brakes per year to individual taxpayers. In the tax bill’s final form, Dr Kelly estimated that approximately 75% of the tax reductions were now being retained by individual taxpayers with only 25% going to businesses. With a larger proportion of the tax breaks going to individual taxpayers that could increase the amount of discretionary income available to the U.S. consumer.

Government Spending (Push)

The anticipated increase in government spending really stems from the Trump agenda that has been communicated. One of the items that he campaigned on was increasing government spending on infrastructure. At this point we do not have many details as to when the infrastructure spending will begin or how much will be spent. Whatever ends up happening, we are not forecasting a dramatic increase or decrease in government spending in 2018.

Investment - Business Spending (+)

Even though business spending only represents 12.7% of our GDP, we could see a sizable increase in spending by businesses in 2018 for the following reasons:

• Corporate tax rate is reduced from 35% to 21%

• The repatriation tax will allow companies to bring cash back from overseas at a low tax rate

• Prior to tax reform, companies already had historically high levels of cash on their balance sheet. What are they going to do with more cash? (See the chart below)

If having more cash was not a large enough incentive by itself for companies to spend money, the new tax rules allowing immediate expensing of the full cost of most assets purchased for the next five years should be. Under the current tax rules, when a business purchases a new piece of equipment, a fleet of trucks, office furniture, whatever it is, the IRS does not allow them to deduct 100% of purchase price in the year that they buy it. They have to follow a "depreciation schedule" and they can only realize a piece of that expense each year. The current tax rules put companies at a tax disadvantage because companies are always trying to shelter as much income as possible from taxation. If Company XYZ buys a piece of equipment that cost $1,000,000, the IRS may require Company XYZ to depreciate that expense over a 10 year period. Meaning they can only realize $100,000 in expenses each year over that 10 year period, even though they already paid the full $1,000,000 for that new piece of equipment.Under the new tax reform, if Company XYZ buys that same new piece of equipment for $1,000,000, they can deduct the full $1,000,000 expense against their income in 2018. Whoa!!! That's huge!! Yes it is and it's a big incentive for companies to spend money over the next five years.

Housing & Net Exports (Push)

We do not expect any significant change from either of these two categories and they represent the smallest portion of our total GDP.

Watch GDP In 2018

The GDP growth rate in 2018 may give us the first indication as to how many "extra innings" we have left in this already long bull market rally. If we do not see a meaningful acceleration in the annual growth rate of GDP above its 2.2% average rate, the rally could be very short lived. On the flip side, if due to tax reform consumer spending and business spending leaps forward in 2018 and 2019, we may be witnessing the longest economic expansion of all time. Time will tell.

Share Buybacks

You will undoubtedly hear a lot about “Share Buybacks” in 2018. Remember, U.S. corporations will most likely have piles of cash on their balance sheets. Instead of spending that money on hiring new employees, buying new equipment, or building a new plant, what else might they do with the cash? The answer, share buybacks.

If a public company like Nike has extra cash, they can go into the market, purchase their own stock, and then get rid of those outstanding shares. Basically it increases the earnings per share for the remaining shareholders.

Example: Let’s assume there are only 4 shares of Nike owned by 4 different people and Nike is worth $100,000. That means that each shareholder is entitled to 25% of that $100,000 or $25,000 each. Now because of tax reform, Nike has $50,000 of extra cash just sitting in its coffers that it otherwise would have paid to the government in taxes. Nike can go into the market with $50,000, purchase 2 shares back from 2 of the shareholders (assuming they would be willing to sell), and then “retire” those two outstanding shares. After that is done, there are 2 outstanding shares remaining but the value of Nike did not change. So the two remaining shareholders, without paying anything extra, now own 50% of Nike, and their shares are worth $50,000 each.

Share buyback may push stock prices higher from a simple math standpoint. If the formula is the value of the company divided by the number of shares outstanding, the fewer shares there are, assuming the value of the company stays the same, the price per share will go up.   The incentive for these share buybacks will most likely be there in 2018. Not only will companies have the cash but share buybacks are a way that public companies can reward their current shareholders..

Is The Stock Market Too Expensive?

The P/E ratio of the S&P 500 Index is another barometer that investors will need to keep a close eye on in 2018. P/E ratios help us to answer the questions: “Is the stock market cheap, fairly valued, or expensive at this point?” The “Forward P/E Ratio” divides the price of a stock by the estimated future 12 months of earnings. The average Forward P/E ratio for the S&P 500 Index between December 1989 – September 30, 2017 was 16.0. As of December 22, 2017, the Forward P/E ratio of the S&P 500 Index is 19.99. In other words, it’s running at 25% above its 25 year historic average. See the chart below:

Conclusion, the U.S. stock market is not “cheap” and it’s a stretch to even classify it as “fairly valued”. I think we are well into what I would consider “expensive territory”. What does that mean for investors? You have to stay on your toes!!

Now, we have an anomaly in the mix with tax reform and history does not speak to how this could play out. If tax reform leads to an acceleration in corporate earnings, that in turn could slow the steady climb in the P/E ratio of the S&P 500 because earnings are the denominator in the formula. If stock prices and earnings are accelerating at the same pace, the stock market can go up without a further acceleration of the P/E ratio. Thus, keeping the stock market from becoming more overpriced and further increasing the risk of owning stocks in the S&P 500.

Summary

In 2018, investors should keep a close eye on the U.S. GDP growth rate, the level of spending by corporations and consumers, the volume of share buybacks by U.S. companies, and the P/E ratio of the S&P 500 Index.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Changes To 529 Accounts & Coverdell IRA's

Included in the new tab bill were some changes to the tax treatment of 529 accounts and Coverdell IRA's. Traditionally, if you used the balance in the 529 account to pay for a "qualified expense", the earnings portion of the account was tax and penalty free which is the largest benefit to using a 529 account as a savings vehicle for college.So what's the change? Prior to the Tax Cuts and Jobs Act (tax reform), qualified distributions were only allowed for certain expenses associated with the account beneficiary's college education. Starting in 2018, 529 plans can also be used to pay for qualified expenses for elementary, middle school, and high school.

Kindergarten – 12th Grade Expenses

Tax reform included a provision that will allow owners of 529 account to take tax-free distributions from 529 accounts for K – 12 expenses for the beneficiary named on the account. This is new for 529 accounts. Prior to this provision, 529 accounts could only be used for college expenses. Now 529 account holders can distribute up to $10,000 per student per year for K – 12 qualified expenses. Another important note, this is not limited to expenses associated with private schools. K – 12 qualified expense will be allowed for:

• Private School

• Public School

• Religious Schools

• Homeschooling

529 Accounts Will Largely Replace Coverdell IRA's

Prior to this rule change, the only option that parents had to save and accumulate money tax-free to K – 12 expenses for their children were Coverdell IRA's. But Coverdell IRA's had a lot of hang ups

• Contributions were limited to $2,000 per year

• You could only contribute to a Coverdell IRA if your income was below certain limits

• You could not contribution to the Coverdell IRA after your child turned 18

• Account balance had to be spend by the time the student was age 30

By contrast, 529 accounts offer a lot more flexibility and higher contributions limits. For example, 529 accounts have no contribution limits. The only limits that account owners need to be aware of are the "gifting limits" since contributions to 529 accounts are considered a "gift" to the beneficiary listed on the account. In 2018, the annual gift exclusion will be $15,000. However, 529 accounts have a provision that allow account owners to make a "5 year election". This election allows account owners to make an upfront contribution of up to 5 times the annual gift exclusion for each beneficiary without trigger the need to file a gift tax return. In 2018, a married couple could contribution up to $150,000 for each child to a 529 account without trigger a gift tax return.If I have a child in private school, they are in 6th grade, and I'm paying $20,000 in tuition each year, that means I have $140,000 that I'm going to spend in tuition between 6th grade – 12th grade and then I have college tuition to pile on top of that amount. Instead of saving that money in an after-tax investment account which is not tax sheltered and I pay capital gains tax when I liquidate the account to pay those expenses, why not setup a 529 account and shelter that huge dollar amount from income tax? It will probably saves me thousands, if not tens of thousands of dollars in taxes, in taxes over the long run. Plus, if I live in a state that allows tax deductions for 529 contributions, I get that benefit as well.

Income Limits and Tax Deductions

Unlike Coverdell IRA's, 529 accounts do not have income restrictions for making contributions. Plus, some states have a state tax deduction for contributions to 529 account. In New York, a married couple filing joint, receive a state tax deduction for up to $10,000 for contribution to 529 account. A quick note, that is $10,000 in aggregate, not $10,000 per child or per account.

Rollovers Count Toward State Tax Deductions

Here is a fun fact. If you live in New York and you have a 529 account established in another state for your child, if you rollover the balance into a NYS 529 account, the rollover balance counts toward your $10,000 annual NYS state tax deduction. Also, you can rollover balances in Coverdell IRA's into 529 accounts and my guess is many people will elect to do so now that 529 account can be used for K – 12 expenses.

Contributions Beyond Age 18

Unlike Coverdell IRA's which restrict contributions once the child reaches age 18, 529 accounts have no age restriction for contributions. We will often encourage clients to continue to contribute their child's 529 account while they are attending college for the sole purpose of continuing to capture the state tax deduction. If you receive the tuition bill in the mail today for $10,000, you can send in a $10,000 check to your 529 account provider as a current year contribution, as soon as the check clears the account you can turn around and request a qualified withdrawal from the account for the tuition bill, and pay the bill with the cash that was distributed from the 529 account. A little extra work but if you live in NYS and you are in a high tax bracket that $10,000 deduction could save you $600 - $700 in state taxes.

What Happens If There Is Money Left In The 529 Account?

If there is money left over in a 529 account after the child has graduated from college, there are a number of options available. For more on this, see our article "5 Options For Money Left Over In College 529 Plans"

Qualified Expenses

The most frequent question that I get is "what is considered a qualified expense for purposes of tax-free withdrawals from a 529 account?" Here is a list of the most common:

• Tuition

• Room & Board

• Technology Items: Computers, Printers, Required Software

• Supplies: Books, Notebooks, Pens, Etc.

Just as important, here are a list of expense that are NOT considered a "qualified expense" for purposes of tax free withdrawals from a 529 account:

• Transportation & Travel: Expense of going back and forth from school / college

• Student Loan Repayment

• General Electronics and Cell Phone Plans

• Sports and Fitness Club Memberships

• Insurance

If there is ever a question as to where or not an expense is a qualified expense or not, I would recommend that you contact the provider of your 529 account before making the withdrawal form your 529 account. If you take a withdrawal for an expense that is not a "qualified expenses" you will pay income taxes and a 10% penalty on the earnings portion of the withdrawal.

Do I Have To Close My Coverdell IRA?

While 529 accounts have a number of advantages compared to Coverdell IRA's, current owners of Coverdell IRAs will not be required to close their accounts. They will continue to operate as they were intended. Like 529 accounts, Coverdell IRA withdrawals will also qualify for the tax-free distributions for K – 12 expenses including the provision for expenses associated with homeschooling.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Pass-Through Income Will Be Taxed For Small Business Owners

While one of the most significant changes incorporated in the new legislation was reducing the corporate tax rate from the current 35% rate to a 21% rate in 2018, the tax bill also contains a big tax break for small business owners. Unlike large corporations that are taxed at a flat rate, most small businesses, are "pass-through" entities, meaning that the profits from the business flow through to the business owner's personal tax return and then are taxed at ordinary income tax rates.While pass-through income will continue to be taxed at ordinary income tax rates, many small business owners will be eligible to deduct 20% of their "qualified business income" (QBI) starting in 2018. In other words, some pass-through entities will only be taxes on 80% of their pass-through income.

Pass-through entities include

Sole proprietorships

Partnerships

LLCs

S-Corps

Unanswered Questions

I wanted to write this article to give our readers the framework of what we know at this point about the treatment of the pass-through income in 2018. However, as many accountants will acknowledge, there seems to be more questions at this point then there are answers. The IRS will need to begin issuing guidance at the beginning of 2018 to clear up many of the unanswered questions as to who will be eligible and not eligible for the new 20% deduction.

Above or Below "The Line"

This 20% deduction will be a below-the-line deduction which is an important piece to understand. Tax lingo makes my head spin as well, so let's pause for a second to understand the difference between an "above-the-line deduction" and a "below-the-line deduction".The "line" refers to the AGI line on your tax return which is the bottom line on the first page of your Form 1040. While both above-the-line and below-the-line deductions reduce your taxable income, it's important to understand the difference between the two.

Above-The-Line Deductions

Above-the-line deductions happen on the first page of your tax return. These deductions reduce your gross income to eventually reach your AGI (adjusted gross income) for the year. Above-the-line deductions include:

• Contributions to health savings accounts

• Contributions to retirement plans

• Deduction for one-half of the self-employment taxes

• Health insurance premiums paid

• Alimony paid, student loan interest, and a few others

The AGI is important because the AGI is used to determine your eligibility for certain tax credits and it will also have an impact on which below-the-line deductions you are eligible for. In general, the lower your AGI is, the more deductions and credits you are eligible to receive.

Below-The-Line Deductions

Below-the-line deductions are reported on lines that come after the AGI calculation. They are comprised mainly of your “standard deduction” or “itemized deductions” and “personal exemptions” (most of which will be gone starting in 2018). The 20% deduction for qualified business income will fall into this below-the-line category. It will lower the income of small business owners but it will not lower their AGI.

However, it was stated in the tax legislation that even though the 20% qualified business deduction will be a below –the-line deduction it will not be considered an “itemized deduction”. This is a huge win!!! Why? If it’s not an itemized deduction, then small business owners can claim the 20% qualified business income deduction and still claim the standard deduction. This is an important note because many small business owners may end up taking the standard deduction for the first time in 2018 due to all of the deductions and tax exemptions that were eliminated in the new tax bill. The tax bill took away a lot of big deductions:

• Capped state and local taxes at $10,000 (this includes state income taxes and property taxes)

• Eliminated personal exemptions ($4,050 for each individual) (Eliminated in 2018)

  • Family of 4 = $4,050 x 4 = $16,200 (Eliminated in 2018)

• Miscellaneous itemized deductions subject to 2% of AGI floor (Eliminated in 2018)

Restrictions On The 20% Deduction

If life were easy, you could just assume that I'm a sole proprietor, I make $100,000 all in pass-through income, so I will get a $20,000 deduction and only have to pay tax on $80,000 of my income. For many small business owners it may be that easy but what's a tax law without a list of restrictions.The restriction were put in place to prevent business owners from reclassifying their W2 wages into 100% pass-through income to take advantage of the 20% deduction . They also wanted to restrict employees from leaving their company as a W2 employee, starting a sole proprietorship, and entering into a sub-contractor relationship with their old employer just to reclassify their W2 wages into 100% pass-through income.

S-Corps

Qualified business income will specifically exclude "reasonable compensation" paid to the owner-employee of an S-corp. While it would seem like an obvious reaction by S-corp owners to reduce their W2 wages in 2018 to create more pass through income, they will still have to adhere to the "reasonable compensation" restriction that exists today.

Partnerships & LLCs

Qualified business income will specifically exclude guaranteed payments associated with partnerships and LLCs. This creates a grey area for these entities. Partnerships do not have a “reasonable compensation” requirement like S-corps since companies taxed as partnerships are not allowed to pay W2 wages to the owners. Also the owners of partnerships are not required to take guaranteed payments. My guess is, and this is only a guess, that as we get further into 2018, the IRS may require partnerships to classify a percentage of a owners total compensation as a “guaranteed payment” similar to the “reasonable compensation” restriction that S-corps currently adhere too. Otherwise, partnerships can voluntarily eliminate guaranteed payments and take the 20% deduction on 100% of the pass-through income.

This may also prompt some S-corps to look at changing their structure to a partnership or LLC. For high income earners, S-corps have an advantage over the partnership structure in that the owners do not pay self-employment tax on the pass-through income that is distribution to the owner over and above their W2 wages. However, S-corp owners will have to weigh the self-employment tax benefit against the option of changing their corporate structure to a partnership and potentially receiving a 20% deduction on 100% of their income.

Sole Proprietors

Sole proprietors do not have "reasonable compensation" requirement or "guaranteed payments" so it would seem that 100% of the income generated by sole proprietors will count as qualified business income. Unless the IRS decides to enact a "reasonable compensation" requirement for sole proprietors in 2018, similar to S-corps. Before everyone runs from a single member LLC to a sole proprietorship, remember, a sole proprietorship offers no liability barrier between the owner and liabilities that could arise from the business.

Income Restrictions

There are limits that are imposed on the 20% deduction based on how much the owner makes in “taxable income”. The thresholds are set at the following amounts:

Individual: $157,500

Married: $315,000

The thresholds are based on each business owner’s income level, not on the total taxable income of the business. We need help from the IRS to better define what is considered “taxable income” for purposes of this phase out threshold. As of right now, it seems that “taxable income” will be defined as the taxpayer’s own taxable income (not AGI) less deductions.

If the owner’s taxable income is below this threshold, then the calculation is a simple 20% deduction of the pass-through income. If the owner’s taxable income exceeds the threshold, the qualified business deduction is calculated as follows:

The LESSER of:

20% of its business income OR 50% of the total wages paid by the business to its employees

Let’s look at this in a real life situation. A manufacturing company has a net profit of $2M in 2018 and pays $500,000 in wages to its employees during the year. That company would only be able to take the qualified business income deduction for $250,000 since 50% of the total employee wages ($500,000 x 50% = $250,000) are less than 20% of the net income of the business ($2M x 20% = $400,000).

This creates another grey area because it seems that the additional calculation is triggered by the taxable income of each individual owner but the calculation is based on the total profitability and wages paid by the company. For the owners that required this special calculation for exceeding the threshold, how is their portion of the lower deduction amount allocated? Multiplying the lower total deduction amount by the percent of their ownership? Just more unanswered questions.:

Restrictions For "Service Business"

There will be restrictions on the 20% deduction for pass-through entities that are considered a "service business" under IRC Section 1202(e)(3)(A). The businesses specifically included in this definition as a services business are:

• Health

• Law

• Accounting

• Actuarial Sciences

• Performing Arts

• Consulting

• Athletics

• Financial Services

• Any other trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees

In a last minute change to the regulations, to their favor, engineers and architects were excluded from the definition of “service businesses”.

This is another grey area. Many small businesses that fall outside of the categories listed above will undoubtedly be asking the question: “Am I considered a service business or not?” Outside of the industries specifically listed in the tax bill, we really need more guidance from the IRS.

If you are a “services business”, when the tax reform was being negotiated it looked like service businesses were going to be completely excluded from the 20% deduction. However, the final regulations were more kind and instead implemented a phase out of the 20% deduction for owners of service businesses over a specified income threshold. The restriction will only apply to those whose “taxable income” exceeds the following thresholds:

Individual: $157,500

Married: $315,000

If you are a consultant or owner of a services business and your taxable income is below these thresholds, it would seem at this point that you will be able to capture the 20% deduction for your pass-through income. As mentioned above, we need help from the IRS to clarify the definition of “taxable income”.

Phase Out For Service Businesses

The amounts listed above: $157,500 for individual and $315,000 for a married couple filing joint, are where the thresholds for the phase out begins. The service business owners whose income rises above those thresholds will phase out of the 20% deduction over the next $50,000 of taxable income for individual filers and $100,000 of taxable income for married filing joint. This means that the 20% pass-through deduction is completely gone by the following income levels:

Individual: $207,500

Married: $415,000

Any taxpayer’s falling in between the threshold and the phase out limit will receive a portion of the 20% deduction.

Since the thresholds are assessed based on the taxpayer’s own taxable income and not the total income of the business, a service business could be in a situation, like in an accounting firm, where the partners with the largest ownership percentage may not qualify for 20% deduction but the younger partners may qualify for the deduction because their income is lower.

Tax Planning For 2018

It's an understatement to say that most small business owners will need to spend a lot of time with their accountant in the first quarter of 2018 to determine the best of course of action for their company and their personal tax situation.While we are still waiting for clarification on a number of very important items associated with the 20% deduction for qualified business income, hopefully this article has provided our small business owners with a preview of things to come in 2018.

Disclosure: I'm a Certified Financial Planner® but not an accountant. The information contained in this article was generated from hours and hours of personal research on the topic. I advise each of our readers to consult with your personal tax advisor for tax advice.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Summary Of The Changes

The conference version of the tax bill was released on Friday. The House and the Senate will be voting to approve the updated tax bill this week with what seems to be wide spread support from the Republican party which is all they need to sign the bill into law before Christmas. Most of the changes will not take effect until 2018 with new tax rates for individuals set to expire in 2025. At which time the tax rates and brackets will return to their current state. Here is a run down of some of the main changes baked into the updated tax bill:

Individual Tax Rates

They are keeping 7 tax brackets with only minor changes to percentages in each bracket. The top tax bracket was reduced from 39.6% to 37%.

Capital Gains Rates

There were no changes to the capital gains rates and they threw out the controversial mandatory FIFO rule for calculating capital gains tax when selling securities.

Standard Deduction and Personal Exemptions

They did double the standard deduction limits. Single tax payers will receive a $12,000 standard deduction and married couples filing joint will receive a $24,000 standard deduction.The personal exemptions are eliminated.

Mortgage Interest Deduction

New mortgages would be capped at $750,000 for purposes of the home mortgage interest deduction.

State and Local Tax Deductions

State and local tax deduction will remain but will be capped at $10,000. An ouch for New York State. That $10,000 can be a combination of your property tax and either sales or income tax (whichever is larger or will get you to the cap of $10,000).Oh and you cannot prepay your 2018 state income taxes in 2017 to avoid the cap. They made it clear that if you prepay your 2018 state income taxes in 2017, you will not be able to deduct them in 2017.

Medical Expense Deductions

Medical expense deductions will remain for 2017 and 2018 and they lowered the AGI threshold to 7.5%. Beginning in 2019, the threshold will change back to the 10% threshold.

Miscellaneous Expense Deductions

Under the current rules, you are able to deduct miscellaneous expenses that exceed 2% of your AGI. That was eliminated. This includes unreimbursed business expenses and home office expenses.

A Few Quick Ones

Student Loan Interest: Still deductible

Teacher Out-of-Pocket Expenses: Still deductible

Tuition Waivers: Still not taxable

Fringe Benefits (including moving expenses): Will be taxable starting in 2018 (except for military)

Child Tax Credit: Doubled to $2,000 per child

Gain Exclusion On Sale Of Primary Residence: No Change

Obamacare Individual Mandate: Eliminated

Corporate AMT: Eliminated

Individual AMT: Remains but exemption is increased: Individuals: $70,300 Married: $109,400

Corporate Tax Rate: Drops to 21% in 2018

Federal Estate Tax: Remains but exemption limit doubles

Alimony

For divorce agreements signed after December 31, 2018, alimony will no longer be deducible. This only applies to divorce agreements executed or modified after December 31, 2018.

529 Plans

Under current tax law, you do not pay taxes on the earnings for distributions from 529 accounts for qualified college expenses. The new tax reform allows 529 account owners to distribute up to $10,000 per student for public, private and religious elementary and secondary schools, as well as home school students.

Pass-Through Income For Business

This is still a little cloudy but in general under the conference bill, owners of pass-through companies and sole proprietors will be taxed at their individual tax rates less a 20% deduction for business-related income, subject to certain wage limits and exceptions. The deduction would be disallowed for businesses offering "professional services" above a threshold amount; phase-ins begin at $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: Your Company May Voluntarily Terminate Your Retirement Plan

Make no mistake, your company retirement plan is at risk if the proposed tax reform is passed.  But wait…..didn’t Trump tweet on October 23, 2017 that “there will be NO change to your 401(k)”?  He did tweet that, however, while the tax reform might not directly alter the contribution limits to employer sponsored retirement plans, the new tax rates will produce a “disincentive” for companies to sponsor and make employer contributions to their plans.

What Are Pre-Tax Contributions Worth?

Remember, the main incentive of making contributions to employer sponsored retirement plans is moving income that would have been taxed now at a higher tax rate into the retirement years, when for most individuals, their income will be lower and that income will be taxed at a lower rate.   If you have a business owner or executive that is paying 45% in taxes on the upper end of the income, there is a large incentive for that business owner to sponsor a retirement plan.  They can take that income off of the table now and then realize that income in retirement at a lower rate.

This situation also benefits the employees of these companies.  Due to non-discrimination rules, if the owner or executives are receiving contributions from the company to their retirement accounts, the company is required to make employer contributions to the rest of the employees to pass testing. This is why safe harbor plans have become so popular in the 401(k) market.

But what happens if the tax reform is passed and the business owners tax rate drops from 45% to 25%?  You would have to make the case that when the business owner retires 5+ years from now that their tax rate will be below 25%.  That is a very difficult case to make.

An Incentive NOT To Contribute To Retirement Plans

This creates an incentive for business owners NOT to contribution to employer sponsored retirement plans.  Just doing the simple math, it would make sense for the business owner to stop contributing to their company sponsored retirement plan, pay tax on the income at a lower rate, and then accumulate those assets in a taxable account.  When they withdraw the money from that taxable account in retirement, they will realize most of that income as long term capital gains which are more favorable than ordinary income tax rates. 

If the owner is not contributing to the plan, here are the questions they are going to ask themselves: 

• Why am I paying to sponsor this plan for the company if I’m not using it?

• Why make an employer contribution to the plan if I don’t have to?

This does not just impact 401(k) plans. This impacts all employer sponsored retirement plans: Simple IRA’s, SEP IRA’s, Solo(k) Plans, Pension Plans, 457 Plans, etc.

Where Does That Leave Employees?

For these reasons, as soon as tax reform is passed, in a very short time period, you will most likely see companies terminate their retirement plans or at a minimum, lower or stop the employer contributions to the plan.  That leaves the employees in a boat, in the middle of the ocean, without a paddle.  Without a 401(k) plan, how are employees expected to save enough to retire?  They would be forced to use IRA’s which have much lower contribution limits and IRA’s don’t have employer contributions.

Employees all over the United States will become the unintended victim of tax reform.  While the tax reform may not specifically place limitations on 401(k) plans, I’m sure they are aware that just by lowering the corporate tax rate from 35% to 20% and allowing all pass through business income to be taxes at a flat 25% tax rate, the pre-tax contributions to retirement plans will automatically go down dramatically by creating an environment that deters high income earners from deferring income into retirement plans.   This is a complete bomb in the making for the middle class.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Tax Reform: At What Cost?

The Republicans are in a tough situation.  There is a tremendous amount of pressure on them to get tax reform done by the end of the year.  This type of pressure can have ugly side effects.  It’s similar to the Hail Mary play at the end of a football game.  Everyone, including the quarterback, has their eyes fixed on the end zone but nobody realizes that no one is covering one of the defensive lineman and he’s just waiting for the ball to be hiked.   The game ends without the ball leaving the quarterback’s hands.

The Big Play

Tax reform is the big play.  If it works, it could lead to an extension of the current economic rally and more.  I’m a supporter of tax reform for the purpose of accelerating job growth both now and in the future.  It’s not just about U.S. companies keeping jobs in the U.S. That has been the game for the past two decades.  The new game is about attracting foreign companies to set up shop in the U.S. and then hire U.S. workers to run their plants, companies, subsidiaries, etc.  Right now we have the highest corporate tax rate in the world which has not only prevented foreign companies from coming here but it has also caused U.S. companies to move jobs outside of the United States.  If everyone wants more pie, you have to focus on making the pie bigger, otherwise we are all just going to sit around and fight over who’s piece is bigger.

Easier Said Than Done

How do we make the pie bigger?  We have to lower the corporate tax rate which will entice foreign companies to come here to produce the goods and services that they are already selling in the U.S.   Which is easy to do if the government has a big piggy bank of money to help offset the tax revenue that will be lost in the short term from these tax cuts. But we don’t.

$1.5 Trillion In Debt Approved

Tax reform made some headway in mid-October when the Senate passed the budget. Within that budget was a provision that would allow the national debt to increase by approximately $1.5 trillion dollars to help offset the short-term revenue loss cause by tax reform.  While $1.5 trillion sounds like a lot of money, and don’t get me wrong, it is, let’s put that number in context with some of the proposals that are baked into the proposed tax reform.

Pass-Through Entities

One of the provisions in the proposed tax reform is that income from “pass-through” businesses would be taxed at a flat rate of 25%. 

A little background on pass-through business income: sole proprietorships, S corporations, limited liability companies (LLCs), and partnerships are known as pass-through businesses. These entities are called pass-throughs, because the profits of these firms are passed directly through the business to the owners and are taxed on the owners’ individual income tax returns. 

How many businesses in the U.S. are pass-through entities?  The Tax Foundation states on its website that pass-through entities “make up the vast majority of businesses and more than 60 percent of net business income in America. In addition, pass-through businesses account for more than half of the private sector workforce and 37 percent of total private sector payroll.” 

At a conference in D.C., the American Society of Pension Professionals and Actuaries (ASPPA), estimated that the “pass through 25% flat tax rate” will cost the government $6 trillion - $7 trillion in tax revenue. That is a far cry from the $1.5 trillion that was approved in the budget and remember that is just one of the many proposed tax cuts in the tax reform package.

Are Democrats Needed To Pass Tax Reform?

Since $1.5 trillion was approved in the budget by the senate, if the proposed tax reform is able to prove that it will add $1.5 trillion or less to the national debt, the Republicans can get tax reform passed through a “reconciliation package” which does not require any Democrats to step across the aisle.  If the tax reform forecasts exceed that $1.5 trillion threshold, then they would need support from a handful of Democrats to get the tax reformed passed which is unlikely.

Revenue Hunting

To stay below that $1.5 trillion threshold, the Republicans are “revenue hunting”.  For example, if the proposed tax reform package is expected to cost $5 trillion, they would need to find $3.5 trillion in new sources of tax revenue to get the net cost below the $1.5 trillion debt limit.

State & Local Tax Deductions – Gone?

One for those new revenue sources that is included in the tax reform is taking away the ability to deduct state and local income taxes.   This provision has created a divide among Republicans. Since many southern states do not have state income tax, many Republicans representing southern states support this provision.   Visa versa, Republicans representing states from the northeast are generally opposed to this provision since many of their states have high state and local incomes taxes.   There are other provisions within the proposed tax reform that create the same “it depends on where you live” battle ground within the Republican party.

Obamacare

One of the main reasons why the Trump administration pushed so hard for the Repeal and Replace of Obamacare was “revenue hunting”.  They needed the tax savings from the repeal and replace of Obamacare to carrry over to fill the hole that will be created by the proposed tax reform.  Since that did not happen, they are now looking high and low for other revenue sources.

Retirement Accounts At Risk?

If the Republicans fail to get tax reform through they run the risk of losing face with their supporters since they have yet to get any of the major reforms through that they campaigned on.  Tax reform was supposed to be a layup, not a Hail Mary and this is where the hazard lies.  Republicans, out of the desperation to get tax reform through, may start making cuts where they shouldn’t.  There are rumors that the Republican Party may consider making cuts to the 401(k) contribution limits and employers sponsored retirement plan.  Even though Trump tweeted on October 23, 2017 that he would not touch 401(k)’s as part of tax reform, they are running out of the options for other places that they can find new sources of tax revenue.  If it comes down to the 1 yard line and they have the make the decision between making deep cuts to 401(k) plans or passing the tax reform, retirement plans may end up being the sacrificial lamb.  There are other consequences that retirement plans may face if the proposed tax reform is passed but it’s too broad to get into in this article. We will write a separate article on that topic.

Tax Reform May Be Delayed

Given all the variables in the mix, passing tax reform before December 31st is starting to look like a tall order to fill.  If the Republicans are looking for new sources of revenue, they should probably look for sources that are uniform across state lines otherwise they risk splintering the Republican Party like we saw during the attempt to Repeal and Replace Obamacare.  We are encouraging everyone to pay attention to the details buried in the tax reform.  While I support tax reform to secure the country’s place in the world both now and in the future, if provisions that make up the tax reform are rushed just to get something done, we run the risk of repeating the short lived glory that tax reform saw during the Reagan Era.   They passed sweeping tax cuts, the deficits spiked, and they were forced to raise tax rates a few years later. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.