The Tax Cuts and Jobs Act (“TCJA”) was one of the most sweeping changes to the tax code in the last 30 years. Here is what you should know to help your clients understand how the TCJA will affect them.
By James C. Penn and Robert S. Metz, CPAs, and Cindi Barela Graham, Family Lawyer
On December 22, 2017, the President signed the Tax Cuts and Jobs Act. There are a number of changes that may have a material impact on property divisions and agreements regarding children.
This article is not a comprehensive summary of all the changes under the TCJA, but outlines some of the more significant tax changes impacting the way family lawyers and financial professionals advise their clients.
Some of the tax changes are permanent and others are temporary. Temporary changes to the tax code are generally set to expire after 2025.
What Family Lawyers Should Know About the Tax Cuts and Jobs Act
Tax Changes Affecting Individuals
The TCJA made revisions to both the tax rates and the taxable income brackets. Changes to individual tax rates are temporary and are set to expire after 2025.
Alimony is no longer deductible by the person paying the alimony nor included in the income of the recipient for all divorce or separation agreements effective after December 31, 2018. This change is not set to expire.
The question of which spouse is able to claim the children as dependents after divorce and receive the associated tax benefits has often been a contested issue. The TCJA repeals the personal exemption, but makes three significant changes to the child tax credit: (1) the credit is doubled to $2,000 for each qualifying dependent child, (3) $1,400 of the credit is now refundable, and (3) the phase-out amounts increase to $400,000 for married taxpayers filing jointly and $200,000 for all other filers. The repeal of personal exemptions and the new child tax provisions are both set to expire after 2025.
Itemized deductions for state, local, and foreign taxes are capped at $10,000 ($5,000 for married filing single). This change potentially makes the cost of owning a marital residence more expensive by limiting itemized deductions for property taxes.
The new law limits the deductible interest on home acquisition indebtedness from $1 million of debt down to $750,000 ($375,000 for married filing separately) for loans originated after December 15, 2017. It also eliminates deductions for interest on home equity loans, unless used to buy, build, or substantially improve the home. This provision is set to expire after 2025.
The TCJA expands qualified education expenses under Section 529 to include up to $10,000 per beneficiary for elementary or secondary school expenses. The change increases flexibility in paying for school before college.
Tax Changes Affecting Businesses
Previously, corporate tax rates fluctuated significantly. The TCJA permanently changed the corporate tax rate to a flat 21%.
Under the TCJA, owners of certain businesses which generate pass-through income may deduct up to 20% of “qualified business income (QBI),” which includes domestic income and gains, net of deductions and losses. The 20% deduction is available without limit for taxpayers whose taxable income does not exceed $315,000 for married filing jointly ($157,500 for individuals). There are additional limitations if taxable income is above those thresholds or the pass-through income is from a service-related business. The QBI deduction is set to expire after 2025.
Starting in 2018, the Section 179 deduction limit is raised to $1 million and the phase-out threshold is raised to $2.5 million. Additionally, for qualifying property purchased between September 27, 2017, and December 31, 2022, 100% of the cost is eligible for write-off through what is called bonus depreciation. For the five years after 2022, the bonus depreciation is phased down by 20% each year.
The TCJA puts new limits on the deductibility of business interest. The current year interest deduction is limited to the sum of (1) the interest income, (2) 30% of the taxpayer’s taxable income, and (3) the taxpayer’s floor plan financing interest for the year (where applicable).
Effects of Tax Changes on Business Valuations
It is important to understand the ways in which the TCJA has affected the application of the different valuation approaches used when valuing closely held businesses included in martial estates. For example, the TCJA has widened the differences in the tax rates applied at the corporate level compared to the rates on pass-through income, which may require adjustments to some of the assumptions applied in valuing businesses. It is important for family law practitioners to discuss with the valuation expert the manner in which these issues have been addressed.
There are several approaches for valuing businesses; however, the TJCA has had a more significant impact on the application of the income and market approaches.
The income approach is applied by forecasting the anticipated future cash flows of the business and then converting those cash flows into a present value. Some of the more salient ways the TCJA may affect valuations using the income approach are as follows:
- The lower tax rates and the 20% QBI deduction generally lower taxes, increase cash flow and, therefore, increase the value of the business.
- Provisions which limit or eliminate tax deductions (including limitations on interest expense deductions) reduce or eliminate the tax shield, thereby reducing cash flows and the value of the entity.
- The changes increasing Section 179 deductions and bonus depreciation generally have a positive impact on cash flows (and, therefore, value) because depreciation is a non-cash expense serving as a tax shield to lower the cash outflows.
- A side effect of the accelerated depreciation allowance will likely be greater capital expenditures by businesses, which increases cash outflows and has a downward effect on value.
- The income approach applies a discount rate in order to present value future cash flows. Generally, the lower the discount rate the higher the value of the business. The discount rate consists of the cost of equity and the cost of debt financing. How the TCJA will affect the cost of equity remains to be seen; however, lower tax rates mean that the tax shield on debt interest payments is lower. Therefore, the after-tax cost of debt is higher, leading to a higher discount rate and lower value.
The market approach determines the value of a business by deriving valuation multiples from other businesses, securities, or intangible assets which have sold and are comparable to the subject interest. Valuation professionals should be cognizant of the date of the information being used to derive the multiples since transactions prior to the TCJA may not reflect the changes under the TCJA. Adjustments to valuation multiples derived from transactions which occurred prior to this date may be necessary.
The tax code is a complicated piece of legislation, and even experts don’t always agree on its application and effects. The Tax Cuts and Jobs Act was one of the most sweeping changes to the tax code in the last 30 years. Practitioners should work closely with financial professionals to help their clients understand how the TCJA will affect them and the assets within their estate.
Previously, funds within a 529 plan could only be used for higher education expenses.
Indexed for inflation.
Floor-plan financing includes loans used for the acquisition of motor vehicles held for sale or lease.
Interest expense which is not deductible in a given tax year may be carried forward indefinitely. Small businesses with less than $25 million in gross receipts and businesses involved in real estate investments/development are excluded.
James C. Penn, CPA/ABV, and Robert S. Metz, CPA/ABV, CFE, are Partners with Whitley Penn, LLP. Cindi Barela Graham, JD, is a solo practitioner at the Law Office of Cindi Barela Graham. www.whitleypenn.com
How the Tax Cuts & Jobs Act Will Impact Corporate Taxes
An overview of how the new tax law could affect the value of major community assets: C-corporations and pass-through entities.
Old Divorce Agreements and the New Tax Bill
A summary of changes in the new Tax Cuts and Jobs Act.
How the TCJA Affects Families – Divorcing or Intact
A look at the provisions of the Tax Cuts & Jobs Act that will affect families – whether or not they are in a state of dissolution.
Thanks for such a comprehensive article. This is very useful and informative.