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By Christine Benz | 12-21-2017 12:00 PM

3 Underdiscussed Tax Changes

Baird's Tim Steffen explores how the Pease Limitation, AMTs, and pass-through changes may affect investors.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. The tax package is set to go into effect in 2018, but some important aspects of it have received less attention. Joining me on the phone to discuss some of them is Tim Steffen. He's director of Advanced Planning for Baird. 

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: Tim, I wanted to discuss some of the lesser-discussed aspects of this tax package, things that we haven't been seeing in the headlines as much. Let's start with this Pease Limitation. Talk about what it is; it's being repealed as part of this tax package. Let's talk about who might, in fact, benefit from the repeal of this Pease Limitation.

Steffen: First, let's explain what the Pease is because probably not a lot of people recognize that name. This goes back to the Tax Reform Act back in the '80s where they instituted a rule, kind of a stealth tax, where it said for people with an income over a certain threshold, you not only have to now pay tax on that income over the threshold, you also begin to lose some of your itemized deductions. As people had their income rising over time, it was kind of a double whammy. You pay tax on the income plus you lose deductions, it's a double tax.

For 2017, that threshold was roughly $313,000 or so for a married couple, so once you got over that threshold, additional income caused you to also lose deductions. That has been repealed effective beginning of 2018. People whose income is rising on a regular basis and is over that threshold will no longer have to worry about that, which means they get to keep more of their itemized deductions. That's an important change, I just don't think a lot of people understand just yet.

Benz: You said you had been running some numbers, actually looking at various profiles of individuals, and we've all seen so much about how state and local and property tax deductions will be capped at $10,000, how that's going to hurt a lot of taxpayers. You actually say that for people who had been subject to this Pease Limitation, even though they are going to lose some of those deductions they're actually maybe in better shape under this tax package than they would have been previously?

Steffen: In some cases, yes. The scenarios I've run show that's probably more the case for somebody who didn't have a lot of state income taxes to begin with. That's a couple of the scenarios we've run have been that case. What the concept here is that, for somebody with a higher level of income, let's say you're somebody who had $500,000 of income. The threshold for you is at roughly $315,000 or so. Income over that you would take 3% of it, and that's how much of your itemized deduction you lose. Somebody at half a million of income was gonna lose about $5,000 of deductions. Now, they're not going to lose that anymore. If the loss of the state income tax thing is not something that's going to really impact them much, or the cap on the state and the property taxes is not a big issue for them, then it could end up being that they end up with more deductions under the new law because they don't have that phase out happening to them anymore.

It's one of those that's a little hard to understand until you run your own numbers through it, but there are going to be scenarios where people, as a result of this, end up with more itemized deductions than they've had in the past.

Benz: I also want to take a look at alternative minimum tax. There are a couple things going on with this tax package at the corporate level as well as at the individual level in relation to the AMT. Let's talk about the individual piece. We're seeing more generous exceptions go into place for AMT as well as the phase outs are actually increasing a lot. Let's talk about how people should think about that. First, though, let's talk about alternative minimum tax, what it was designed to do in the first place.

Steffen: The AMT or the alternative minimum tax is exactly what it says. It's an alternative way to calculate your tax liability. It's got its own set of rules on what's deductible and what's not, what's taxable and what isn't. You run through a separate set of calculations on a different form in your tax return, come up with a different taxable income amount, you apply a different set of rates and brackets to it to come up with a different tax amount. Then you pay the [greater] of either that or what you came up with the regular system that we're all pretty familiar with. It's exactly what it says, an alternative minimum tax. 

It's something that was tripping up a lot of taxpayers, especially those that maybe paid a lot in state income taxes or property taxes, maybe some corporate executives who had certain benefits, people with a lot of kids tended to pay more AMT, so it was, again, one of those stealth tax things that really caused a lot of extra expense for a lot of taxpayers.

Benz: Let's talk about what changing in general. Fewer people will fall into the AMT zone it sounds like.

Steffen: In general, I think, that's a fair way to describe it. What's happening is two things, really. First off, there's an exemption amount that, the certain amount of your income that just isn't subject to AMT. That's increasing pretty significantly. For a married couple it's going up from about $79,000 roughly to over $109,000. That's a fairly big jump up. For singles it's going from about $50,000 to about $70,000. Again, another big jump up. That's the amount of your income that is automatically exempted from AMT. 

The other thing that's happening is that there's a phase out that applies to that exemption. Once your income crosses a certain threshold, you begin to lose that exemption from the AMT. For a married couple in 2017, that phase out starts happening at about $150,000 income. That's going to change next year to $1 million of income. Not only do you get a larger exemption, but it's going to be a lot harder to be phased out of it. The combination of those two means fewer people will be paying AMT in 2018 than have been in the past.

Benz: One of the implications of this or one of the takeaways you have said is that, if you are going to exercise incentive stock options that, from a tax standpoint, not from an investment standpoint but from a tax standpoint, may make sense to delay if you can.

Steffen: Those incentive stock options are the ones that have caused a lot of executives and employees of small businesses, even, to be subject to the AMT. With AMT being harder to get into, or easier to avoid maybe is a better way to say it for 2018, it can make some sense to delay those option exercises into 2018. In other words, you might be able to exercise more of the options next year and avoid paying any tax on those than you might be able to do in 2017.

Benz: Now I want to talk about pass-throughs. There have been a lot of people joking, should I structure myself as a pass-through in order to try to reduce my taxes down the line? First, let's talk about what's going on with pass-through businesses, what constitutes a pass-through business, and also in what situations might in fact this might make sense for someone to structure their small business as some sort of a pass-through.

Steffen: When we're talking about a pass-through, we're talking about a business that's structured as either an S corporation, a partnership, or a sole proprietorship. You don't often think of sole proprietorships in that same group, but they're considered a pass-through as well. These are businesses that don't pay tax on their own but instead pass through the income to their owners and the owners pay taxes on their own personal tax returns. In order to try and keep things equal between these pass-through entities and your traditional C corporations that pay taxes on their own, one of the provisions in this bill would be that these pass-throughs could now exempt 20% of their income from tax so they get a deduction for 20% of their gross income. But, like a lot of things, there's a lot of limitations as to how this applies, but it is something that business owners are going to want to take a closer look at.

For example, some of the variables to consider are going to be how much of your income, or how much income to you get from this business in your income overall? For couples with income under roughly $300,000 or so, they're going to get the full benefit of this deduction. For those over it, there may be some other tests that they have to look at to determine just how much of their, of this 20% deduction, they can really take. And those are going to be dependent on things like, what is the nature of your business? If you're considered a service corporation, it's going to be harder for you to qualify for this. Service corporations, those are the accountants and the attorneys and the performing artists and the consultants and those kinds of things. They're going to have a harder time getting a benefit out of this new deduction.

The other thing is if you don't have employees. One of the provisions they put in there is it said, well, your deduction is, may be limited to how much you paid in wages to the employees who work for you. If you're a sole proprietor who doesn't have employees and you have income over that $300,000 threshold or so for a couple, it's going to be harder for you to qualify for this 20% deduction. 

The three factors you really need to look at is how much total income you have, what type of business you are and if you have employees or not.

Benz: It seems like in all of these cases, Tim, people would probably want to get some additional tax guidance before going forward, but we thank you so much for providing these tips. Really helpful stuff. Thank you for being here.

Steffen: Happy to do it, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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