Tax planning following the Tax Cuts and Jobs Act.

• Author: Sarenski, Theodore J.

The legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made sweeping changes to the tax law, reducing the C corporation top income tax rate from 35% to 21%, creating a 20% tax deduction for qualified business income under new Sec. 199A, limiting the state and local tax (SALT) deduction to $10,000, increasing the standard deduction to 112,000 for single taxpayers and $24,000 for married taxpayers filing joindy, doubling the estate tax applicable exclusion amount, eliminating the ability to recharacterize Roth IRA conversions, expanding the scope of Sec. 529 education plans, further limiting interest deductions, and doubling the Sec. 179 expensing amount. This column discusses some of the planning implications of these changes.

Entity choice: C corp. vs. passthrough entity

While the TCJA improved the tax consequences for both C corporations and the owners of passthrough entities, the improvements for C corporations were more substantial. Thus, C corporations are somewhat more favorable relative to passthrough entities following passage of the TCJA. The tax rate on operating income dropped by 40% for C corporations (35% to 21%), but only by 25.25% (39.6% to 29.6%) for passthrough entities that fully qualify for the 20% Sec. 199A deduction (top individual rate of 37% x 80% of income). This means that the initial tax on C corporation income may now be significantly lower for C corporations than for S corporations (21% vs. 29.6%). In addition, the TCJA limits the SALT deduction to $10,000 for individuals but imposes no limit on the deduction for C corporations. Finally, the new C corporation rate is permanent, while the 20% Sec. 199A deduction sunsets at the end of 2025.

The overall tax paid on passthrough entities will generally continue to be lower, however, because of the second level of tax on C corporation owners when the income is distributed or the stock is sold. Dividends are generally taxed at 23.8% for affluent shareholders who are subject to the net investment income tax, and the same 23.8% rate applies to sales of C corporation stock. This almost doubles the effective tax rate on C corporation income: [0.21 + (0.79 x 0.238)] = 0.21 + 0.18802 = 39.802%.

However, two factors may increase the effective rate of tax for S corporations or decrease the effective tax rate for C corporations. There are important limitations on the Sec. 199A deduction, so it might not help some passthrough businesses very much. Some will lack the W-2 wages or basis in property necessary to gain a significant benefit from the new deduction. This might substantially increase the rate of tax paid on passthrough income, perhaps to as high as the top individual rate of 37%.

In addition, C corporations may be able to mitigate the effects of the second level of tax. First, the second level of tax is not payable until the income is distributed as a dividend or until the stock is sold. If shareholders do not need the dividends, there could be substantial tax deferral. Second, the second level of tax might never be paid at all. If dividends are not paid and the shareholder dies while owning the stock, the heirs will receive a step-up in basis, eliminating the increase in the stock's value due to the retained earnings. Third, C corporations can pay shareholder-employees deductible wages, fringe benefits, and deferred compensation instead of dividends. Thus, comparing the effective tax rates for C corporations and passthrough entities will require a detailed analysis of the facts of each case.

SALT deduction and incomplete gift nongrantor (ING) trusts

Taxpayers who live in high-tax states like New York and California have long created trusts in other states that do not tax trust income to eliminate their state income tax exposure. The most popular states for these trusts are Nevada, where the trusts are referred to as NINGs (Nevada incomplete gift nongrantor trusts), and Delaware, where they are referred to as DINGs (Delaware incomplete gift nongrantor trusts). These trusts have always been capable of creating dramatic tax savings over time or perhaps on a sale of a highly appreciated asset, but the savings will be substantially greater following enactment of the $10,000 limit on the SALT deduction, as...