(973) 403-9200
Charles F. Vuotto, Jr., JD-
Susan Miano, CPA, ABV, CFF
The Tax Cuts and Jobs Act (or the “TCJA”) is the most significant tax legislation in the last few decades, generating much discussion. In its wake, a flurry of ongoing clarifying guidelines are being issued by the Internal Revenue Service. The American Institute of Certified Public Accountants, along with 40 national trade associations, submitted a comment letter to the Department of the Treasury and the IRS for much-needed guidance regarding many muddy provisions of the TCJA. In fact, this very article is undoubtedly one of many that has crossed your desk. As of this writing, the IRS has provided its early-release draft of Form 1040 for 2018, but it is still unclear when over 450 revised income tax forms for fiscal year 2018 (the year the TCJA is effective), instructions, and codifications will be issued in final form by the Department of the Treasury.[i] One thing is clear: the TCJA has as many proponents as detractors. Examples of who may be happy with TCJA include:
However, there are just as many who may be unhappy, such as:
Tax Rates
It is fair to assume that the U.S. Individual Income Tax Return (Form 1040) will experience a pretty significant makeover, with draft forms available for viewing at https://www.irs.gov/pub/irs-dft/f1040–dft.pdf. What we do know is that while there are still seven tax rates, they have changed and will remain in effect until they “sunset” in 2025:
| Married Taxpayers Filing Jointly | |||||||||
| 2017 – Prior Law | 2018 – New Law | ||||||||
| Tax Rate | If taxable income is: | Tax Rate | If taxable income is: | ||||||
| 10% | $0 to $19,050 | 10% | $0 to $19,050 | ||||||
| 15% | $19,051 to$77,400 | 12% | $19,051 to$77,400 | ||||||
| 25% | $77,401 to $156,150 | 22% | $77,401 to $165,000 | ||||||
| 28% | $156,151 to $237,950 | 24% | $165,001 to $315,000 | ||||||
| 33% | $237,951 to $424,950 | 32% | $315,001 to $400,000 | ||||||
| 35% | $424,951 to $480,050 | 35% | $400,001 to $600,000 | ||||||
| 39.6% | $480,051 or more | 37% | $600,001 or more | ||||||
|
Married Taxpayers Filing Separately |
|||||||||
| 2017 – Prior Law | 2018 – New Law | ||||||||
| Tax Rate | If taxable income is: | Tax Rate | If taxable income is: | ||||||
| 10% | $0 to $9,525 | 10% | $0 to $9,525 | ||||||
| 15% | $9,526 to $38,700 | 12% | $9,526 to $38,700 | ||||||
| 25% | $38,701 to $78,075 | 22% | $38,701 to $82,500 | ||||||
| 28% | $78,076 to $118,975 | 24% | $82,501 to $157,500 | ||||||
| 33% | $118,976 to $212,475 | 32% | $157,501 to $200,000 | ||||||
| 35% | $212,476 to $240,025 | 35% | $200,001 to $300,000 | ||||||
| 39.6% | $240,026 or more | 37% | $300,001 or more | ||||||
| Head of Household | ||||
| 2017 – Prior Law | 2018 – New Law | |||
| Tax Rate | If taxable income is: | Tax Rate | If taxable income is: | |
| 10% | $0 to $13,600 | 10% | $0 to $13,600 | |
| 15% | $13,601 to $51,850 | 12% | $13,601 to $51,800 | |
| 25% | $51,851 to $133,850 | 22% | $51,801 to $82,500 | |
| 28% | $133,851 to $216,700 | 24% | $82,501 to $157,500 | |
| 33% | $216,701 to $424,950 | 32% | $157,501 to $200,000 | |
| 35% | $424,951 to $453,350 | 35% | $200,001 to $500,000 | |
| 39.6% | $453,351 or more | 37% | $500,001 or more | |
| Single | ||||
| 2017 – Prior Law | 2018 – New Law | |||
| Tax Rate | If taxable income is: | Tax Rate | If taxable income is: | |
| 10% | $0 to $9,525 | 10% | $0 to $9,525 | |
| 15% | $9,526 to $38,700 | 12% | $9,526 to $38,700 | |
| 25% | $38,701 to $93,700 | 22% | $38,701 to $82,500 | |
| 28% | $93,701 to $195,450 | 24% | $82,501 to $157,500 | |
| 33% | $195,451 to $424,950 | 32% | $157,501 to $200,000 | |
| 35% | $424,951 to $426,700 | 35% | $200,001 to $500,000 | |
| 39.6% | $426,701 or more | 37% | $500,001 or more | |
It is important for matrimonial attorneys to be aware of these lowered rates for a number of reasons, most importantly for projecting post-divorce net, after-tax cash flows for support purposes.
It is interesting to note that in the post-TCJA world, previously favorable “Head of Household” tax rates (as compared with “Single” rates) have been eliminated for income at the 24% rate and above. Therefore, the “Single” and “Head of Household” tax rates are identical for taxable income of $82,501 and above. However, the “Head of Household” filing status still edges out the “Single” filer for the standard deduction ($18,000 Head of Household vs. $12,000 Single, discussed in greater detail below).
Practice tip: The designation of a parent as “Head of Household” for a child or children should be expressly addressed in any marital settlement agreement. Both parents of dependent children may file as “Head of Household” if there is more than one dependent child and they identify which child is deemed their respective dependent. In cases when one child is a dependent of two taxpayers, and both are eligible to claim dependency, they may alternate years filing as Head of Household. Two taxpayers may not file as Head of Household simultaneously when only one child is their dependent.
Exemptions
Personal exemptions have been repealed until 2025, meaning that deductions from income in 2017 of $4,050 each for yourself, your spouse and dependent children are no longer allowed until 2026. However, the child tax credit (effectively cash back from the IRS) has doubled from $1,000 to $2,000 per child and phase-out limits have increased from $110,000 to $400,000 (for married taxpayers) and from $75,000 to $200,000 (for single taxpayers), resulting in this credit being available to many taxpayers who could previously could not take advantage of it. These credits are dollar-for-dollar reductions of federal taxes owed; the refundable portion has increased to $1,400 (from $1,000).
Tax Credits and Other Incentives
While we are on the topic of tax credits available for families with dependent children, the TCJA made no changes with respect to education credits. There are two credits available: the American Opportunity Tax Credit (the “AOC”) and the Lifetime Learning Credit (the “LLC”). The AOC allows families of undergraduates to deduct the first $2,000 spent on qualified education expenses and 25% of the next $2,000. To qualify for the full credit in 2018, single parents must have an adjusted gross income of $80,000 or less ($180,000 or less if married and filing jointly). This credit may be claimed for only four years and the total credit cannot exceed $2,500. The LLC differs from the AOC in that there is no limit to the number of years this credit can be claimed, and it covers such education-associated expenses as post-graduate courses, job skill courses, or single undergraduate courses. The LLC offers up to a $2,000 tax credit on the first $10,000 of education expenses so long as adjusted gross income is $57,000 or less in 2018 for a single filer ($114,000 or less if married filing jointly). Practice tip: These credits cannot be claimed if taxpayers are Married Filing Separately. Also, taxpayers must choose one of these two credits per child.
One important point to remember is that although dependency exemptions are eliminated, the notion of “dependents” (also referred to as qualifying children) still exists. Dependency tests (relationship, residency, age, and support) remain in place to determine whether or not one can take advantage of the child tax credit, as well as education credits and child and dependent care credits.[ii]
Practice tip: Head of Household, Dependency Exemptions, Child Tax Credits, the American Opportunity Tax Credit and the Lifetime Learning Credit should all be addressed in the marital settlement agreement. Even though the personal exemption has been repealed until 2025, it still should be addressed in any agreement since, depending on the age of the children, it may become relevant in the future. Further, the child tax credit, due to the increased value and heightened phase-out, is a valuable item that should also be addressed in the marital settlement agreement. In instances where two taxpayers equally share custody of dependent children, parents may alternate years of taking these tax credits.
While we are on the topic of kids, the “kiddie tax” has been modified. The “kiddie tax” refers to taxation (prior to 2018) of the income of dependent children at the parents’ marginal tax rates. For tax years commencing in 2018 and ending in 2025, income tax rates imposed on trusts will be applied at the maximum trust rate of 37% beginning at $12,500, and not the maximum personal tax rate of 37% beginning at $400,000 for those who are Married Filing Jointly, resulting in parents paying more taxes on interest earned on dependent children’s UTMA accounts, for example.
The TCJA does attempt to provide assistance to families with children by allowing earlier access to 529 Plans. The TCJA allows families to utilize moneys set aside in 529 Plans to fund private primary and high-school tuition up to $10,000 per child. There continues to be no limitation on 529 Plan withdrawals for college costs.
Practice tip: When drafting marital settlement agreements in cases where 529 Plans exist or are contemplated, it is now critical to identify whether these funds will be used for private primary and high-school tuition up to $10,000 per child or limited to college only.
Deductions
The standard deduction for each filing status has nearly doubled across the board, as follows:
Pre TCJA Post TCJA
Single or Married Filing Separately $ 6,350 $12,000
Married Filing Jointly 12,700 24,000
Head of Household 9,350 18,000
For certain filers, this may actually offset the loss of certain valuable deductions such as for state and local income taxes. These standard deductions will remain in effect until 2025. Again, this is critical in determining parties’ post-divorce net, after-tax cash flows for support purposes.
The TCJA continues to provide taxpayers who incur certain expenses that are in excess of the standard deduction with opportunities to deduct them (subject to certain thresholds) from income in the calculation of income taxes. However, it is fair to assume that Schedule A (where itemized deductions are reported), will have a new look, at least through 2025, to reflect the following:
Beginning in 2018, only active-duty members of the armed forces can deduct moving-related expenses. Further, certain qualified moving expenses paid by employers which were previously excluded from gross income are now included in AGI, except for active duty members of the armed forces.
Investments and Personal Assets
There are many provisions in the tax laws that remain unchanged with respect to capital assets and investments. Long-term capital gains taxation rates remain at 0%, 15% and 20%, depending on the taxpayer’s federal tax rate. (Short-term capital gains are generally taxed at ordinary rates.) Also, no change has occurred with respect to the exclusion of the gain from the sale of a principal residence ($500,000 for joint filers and $250,000 for single). Net investment income tax of 3.8% and Medicare surtax (on wages and self-employment income) of .9% both continue (for married taxpayers filing jointly with AGI of $250,000 and above). However, losses related to casualty or theft losses will generally no longer be deductible, unless in a federally-declared disaster area.
Alimony
Arguably, for family law practitioners, one of the most dramatic provisions of the TCJA is the repeal of the taxability and deductibility of alimony payments between divorced persons. This provision, unlike the changes discussed above which are effective January 1, 2018 and “sunset” in 2025, is permanent (unless the Legislature decides to change the law again), and is effective in tax years beginning January 1, 2019. It is important to note that the January 1, 2019 effective date refers to parties who have executed a marital settlement agreement on January 1, 2019 or thereafter. Therefore, if divorcing parties execute a marital settlement agreement on December 31, 2018 or prior, but do not obtain a decree of divorce until some date in 2019 (or after), alimony is still taxable and deductible to the parties as it was in the pre-TCJA world. In such a case, it may be wise to state explicitly in any agreement that the alimony shall be taxable notwithstanding the TCJA. An example of such language is as follows:
“The parties acknowledge that pursuant to the “Tax Cuts and Jobs Act of 2017” (TCJA) signed into law on December 22, 2017, Alimony is no longer taxable to the recipient or deductible as to any Agreement or Judgment entered after December 31, 2018. Since this Agreement is being executed prior to said date, the alimony shall continue to be taxable and deductible in accordance with prior law. The parties further acknowledge that the intended tax treatment of this Alimony is an essential part of this Agreement. Should there be any change in the Internal Revenue Code or other tax laws, which affect the intended taxability of this Alimony, said occurrence shall constitute a substantial change in circumstances justifying a modification of the amount of said Alimony.”
These new rules do not apply to existing divorces. However, as of this writing it is unclear how the new tax law applies if parties have an existing (pre-2019) divorce decree in place and alimony as set forth in their marital settlement agreement is legally modified in 2019 or thereafter. The Conference Report to Accompany H.R. 1 of the Tax Cuts and Jobs act provides some language regarding the effective date, which reads:
(c) EFFECTIVE DATE. —The amendments made by this section
shall apply to—
(1) any divorce or separation instrument (as defined in
section 71(b)(2) of the Internal Revenue Code of 1986 as in effect before the date of the enactment of this Act) executed after December 31, 2018, and
(2) any divorce or separation instrument (as so defined) executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modification.
It is fair to assume that most professionals are currently working to understand and apply these changes. Some professionals believe that the above quoted language allows the continued pre-TCJA tax treatment (i.e., alimony is tax deductible to the payer and income to the recipient) if an agreement or order is entered on or before December 31, 2018 and later modified provided that the agreement or order does not expressly provide that the new law applies. Still other professionals believe that it is unclear whether alimony related to divorce instruments executed on or before December 31, 2018, and thereafter modified after December 31, 2018, will be taxable/deductible.
Practice tip: Although this provision is a “permanent” one, it is uncertain whether it may be repealed in the near (or distant) future. Therefore, family law practitioners may wish to include language in marital settlement agreements where the parties acknowledge that taxable alimony was modified in a post-TCJA world and that the parties wish the tax treatment to continue. An example of such language is as follows: “The parties acknowledge that pursuant to the “Tax Cuts and Jobs Act of 2017” (TCJA) signed into law on December 22, 2017, Alimony is no longer taxable to the recipient or deductible as to any Agreement or Judgment entered after December 31, 2018. Since this is an Agreement to modify taxable alimony agreed upon prior to enactment of the TCJA, the parties expressly agree herein that the modified alimony provided for herein shall continue to be taxable to the payee and deductible by the payer in accordance with prior law. The parties further acknowledge that the intended tax treatment of this Alimony is an essential part of this Agreement. Should there be any change in the Internal Revenue Code or other tax laws, which affect the intended taxability of this Alimony, said occurrence shall constitute a substantial change in circumstances justifying a modification of the amount of said Alimony.”
Strategies for negotiating alimony must change as to any agreement or judgment addressing alimony entered after December 31, 2018 (that is not modifying a pre-TCJA agreement/judgment). To the extent Rules of Thumb were used (contrary to case law[iii]), they cannot apply any longer. It is suggested that parties’ post-divorce, after-tax cash flows (after considering child support) must be computed and analyzed in conjunction with the statutory factors under N.J.S.A. 2A:34-23 (b).
Also, practitioners may wish to include a statement by the parties that they have consulted with their tax advisors with respect to this issue.
Taxation of Businesses
Besides the sweeping changes to individual taxation, the TCJA also addresses businesses– whether they are “C” corporations filing Forms 1120 that are taxed at the entity level, or “pass-though” entities (e.g.,“S” corporations, limited liability companies, and partnerships) that file Forms 1120S or Forms 1065.
The corporate tax rate is permanently fixed at a flat 21% and the corporate alternative minimum tax (AMT) has been repealed for tax years after December 31. 2017.
The deduction for net interest expense incurred by businesses with annual gross receipts of more than $25 million is now limited to the sum of business interest income, 30% of the business’s adjusted taxable income and floor plan financing interest (generally pertains to auto dealers). Before January 1, 2022, adjusted taxable income is defined as taxable income exclusive of items not allocable to a trade or business, business interest income and deductions, depreciation, amortization, and depletion. For tax years beginning on or after January 1, 2022, depreciation, amortization and depletion are included in the calculation of adjusted taxable income. A taxpayer may elect to be excluded from the interest deduction limitation provision if he or she is engaged in real property trades or businesses (e.g., real property development, construction, rental, management, leasing, brokerage trade or business). Disallowed interest expense may be carried forward indefinitely.
Businesses who entertain their clients, prospects and business associates will feel some TCJA-related discomfort. The deductibility of the “two-martini lunch” has long-been limited to a 50% deduction when associated with a trade or business. These meals are differentiated from fully deductible costs of food and beverages provided, for example, to employees for the convenience of the employer (e.g., the “working lunch.”). The TCJA now limits deductibility of these “de minimis fringe benefits” to 50%. Further, the TCJA repeals the deductibility of entertainment and recreation expenses directly associated with conducting business, eliminating deductions for activities considered entertainment, amusement or recreation, and membership dues for recreational or social clubs. Therefore, in the post-TCJA world, only the “dinner” portion of the “dinner and a show” with clients is deductible (at 50%). It is not clear whether the IRS considers the hot dogs purchased at the ballpark an inextricable part of attending opening day at Yankee Stadium with your clients (clearly entertainment) and therefore no longer deductible as a “meal” – a conundrum, indeed! Practice tip: While meals and entertainment deductions will be shrinking, businesses may redirect spending toward fully-deductible employee incentives such as 401(k) and SEP contributions.
Section 179 of the Internal Revenue Code allows businesses to deduct the entire cost of depreciable business equipment the year it is acquired instead of capitalizing it and depreciating the asset over the years of its useful life. This is offered as an incentive to businesses to purchase new equipment and grow their businesses. The TCJA increased the maximum annual Section 179 deduction to $1 million (from $500,000) and increased the phase out threshold to $2.5 million of total amount of equipment purchases (from $2 million in 2017).
The TCJA also increases the depreciation limitations for passenger cars placed in services after 12/31/17 to $41,360 over the first 4 years.
Finally, the TCJA has enacted a new deduction for certain pass-through entities which are subject to expire in 2025 that is particularly complex and has many practitioners scratching their heads while waiting for guidance and clarification from the IRS. This new provision generally allows an individual to deduct 20% of his/her “qualified business income” from a partnership, S corporation or sole proprietorship, subject to limitations. This deduction generally applies to all pass-through income that does not exceed $315,000 (for married filers). However, if the business exceeds this income threshold (subject to a brief phase-out) and is engaged in certain “specified trades or business” whose “principal asset is reputation or skill” such as accountancy, healthcare, law, consulting and financial services, it is ineligible. Two exceptions to this rule are businesses engaged in engineering and architecture, which are eligible. Eligible businesses may take the 20% pass-through deduction limited to the lesser of (a) 20% of the taxpayers’ combined qualified business income, or (b) the greater of 50% of the wages paid by the company related to the qualified business or 25% of the wages paid by the company related to the qualified business plus 2.5% of the unadjusted basis (cost) of qualifying fixed assets (depreciable tangible property that is used in the qualified business).
Please note that New Jersey’s governor signed a bill during early July 2018 that will create state income tax adjustments that will disallow this deduction for New Jersey personal income tax purposes.
Practice tip: After-tax cash flows to owners of certain “qualifying” pass-through businesses can vary greatly in a pre-and post-TCJA world. Further, two businesses with identical pass-through income as reported on their respective Forms K-1 may yield vastly different after-tax income (cash flow) to the owners depending upon the trade or business in which a company is engaged. For example, an accountant and an architect with otherwise identical income tax returns (both having been issued similar Forms K-1 with net income of $500,000) would have the same tax liability in 2017. However, in 2018, if the architect’s business qualifies for the pass-through deduction, total taxes due may be significantly less, resulting in greater after-tax cash flow as compared with her accountant counterpart. Therefore, litigants’ professions and associated tax consequences are to be considered for purposes of support (after-tax cash flows) and equitable distribution (valuation of the business).
Business Valuation
Practitioners must consider the impact that the TCJA will have on business valuation, the extent of which is difficult to generalize. The permanent reduction of the corporate income tax rate (from a maximum of 35% to a flat 21%) may, all things held equal, result in an increase in business values across the board. However, there are other aspects of the TCJA that may counter the impact of new tax rates. For example, the reduced corporate tax rate may change after-tax cost of debt and resultant weighted average cost of capital. Changes to the depreciation thresholds and deductibility of interest expense may affect corporate policies with respect to investments in capital assets. When employing a market approach, care must be taken to consider that pre-TCJA guideline valuation multiples (such as price-to-net income) and sales transactions may not reflect the impact of new tax rates, and all else being equal, may produce an unreliable estimate of value. Obviously, methodologies for tax-affecting pass-through entities must be carefully considered. Therefore, there are many new factors that must be considered when valuing a business in the post-TCJA world; those presented here representing only a brief list of factors that must be considered. A more expansive analysis, beyond the scope of this article, is necessary to fully address the TCJA and its impact on business valuation.
Conclusion
The foregoing is a sampling of the comprehensive changes set forth by the Tax Cuts and Jobs Act. We have no doubts that the Internal Revenue Service has challenges ahead of it as it begins to provide guidance, clarification and ultimately, administration, of this tax code make-over. Our challenge as family law professionals is to gain a comprehensive understanding of these changes, adapt to these changes, and to continue our roles as well-informed, well-prepared and trusted professionals.
DISCLAIMER
Professional accounting and legal services are necessarily fact-sensitive, particularly in a litigation context. Therefore, readers are encouraged to apply their expertise to particular fact patterns that they encounter, or to seek competent professional assistance as warranted in the circumstances. Views expressed in this article do not necessarily reflect the professional opinions or positions that the authors would take in an actual litigation matter. Nothing contained in these written materials shall be construed to constitute the rendering of professional legal or accounting advice.
Charles F. Vuotto, Jr., Esq. is Of Counsel with Starr, Gern, Davison & Rubin, PC in Roseland, New Jersey, Past Chair of the NJSBA Family Law Section, Fellow of the AAML and Editor-in-Chief of the New Jersey Family Lawyer. Susan Miano, CPA is a partner with Friedman LLP in East Hanover, New Jersey.
[i] Early release drafts can be found at IRS.gov/LatestForms.
[ii] In order to qualify as a dependent a qualifying child must meet the following tests:
[iii] “It goes without saying that the final alimony order in this case should take into consideration the real facts and circumstances of each party’s financial situation including actual income, expenses, support from other sources and potential earning capacity. Income should not be imputed where real figures are available. No rule of thumb or percentage should be applied. Di Tolvo v. Di Tolvo, 131 N.J.Super. 72, 328 A.2d 625 (App.Div.1974). Such mechanisms have no place in judicial decision making.” Connor v. Connor, 254 N.J. Super. 591, 604 (App. Div. 1992)