Income Tax in the United States
In the United States, a tax is imposed on income by the federal, most state, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income.
Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. An alternative tax applies at the federal and some state levels.
Taxable income is total income less allowable deductions. Income is broadly defined. Most business expenses are deductible. Individuals may also deduct a personal allowance (exemption) and certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits.
Capital gains are taxable, and capital losses reduce taxable income to the extent of gains (plus, in certain cases, $3,000 or $1,500 of ordinary income). Individuals currently pay a lower rate of tax on capital gains and certain corporate dividends.
Taxpayers generally must self assess income tax by filing tax returns. Advance payments of tax are required in the form of withholding tax or estimated tax payments. Taxes are determined separately by each jurisdiction imposing tax. Due dates and other administrative procedures vary by jurisdiction. April 15 following the tax year is the last day for individuals to file tax returns for federal and many state and local returns. Tax as determined by the taxpayer may be adjusted by the taxing jurisdiction.
Corporate Income tax - two types -S Corp Vs C Corp
C corporations are subject to double taxation; that is, one tax at the corporate level on the corporation's net income, and another tax to the shareholders when the profits are distributed. S corporations have only one level of taxation. All of their income is allocated to the shareholders.
United States tax code allows certain types of entities to utilize pass-through taxation. This effectively shifts the income tax liability from the entity earning the income to those who have a beneficial interest in it. The Schedule K-1 is the form that reports the amounts that are passed through to each party that has an interest in the entity.
Similar to a partnership, S corporations must file an annual tax return on Form 1120S.The S corporation provides Schedule K-1s that reports each shareholder’s share of income, losses, deductions and credits. The shareholders use the information on the K-1 to report the same thing on their separate tax returns.
The Tax Cuts and Jobs Act 2018 made a lot of changes to the existing tax code. Most of them begin in 2018 and they’re a lot to get your mind around. If you’ve historically chosen to itemize rather than take the standard deduction, here's what you need to know in the years going forward.
The TCJA tweaks and even eliminates a good many itemized deductions, but most of the changes are temporary. They’ll expire in 2025 unless Congress votes to keep some or all of them. Meanwhile, you might want to plan accordingly if you’ve normally claimed some or all of these deductions.
The Medical Expenses Deduction
The changes to the itemized deduction for medical expenses is actually pro-taxpayer, at least for a short time.
You could only claim a deduction for the portion of your expenses that exceeded 10 percent of your adjusted gross income through the 2016 tax year. The TCJA reduces that threshold to 7.5 percent, although only for tax years 2017 and 2018. This provision is retroactive, so you get a little gift as you go about preparing your 2017 return—you’ll be able to deduct somewhat more in medical expenses.
The other rules remain the same. You can claim expenses incurred for yourself, your spouse, or your dependents, and you must have paid them in the same year you claim them as a deduction. The 7.5 percent threshold is scheduled to increase back up to 10 percent in 2019, so you might want to spend the money now rather than later if you’re considering elective procedures that are deductible under the law. Just keep in mind that cosmetic-type surgeries and treatments are not deductible, although those that are preventative and those that treat existing problems are.
The State and Local Taxes Deduction (SALT)
This deduction was a matter of hot debate as the TCJA made its way through Congress at the end of 2017. It used to be unlimited, and it covered a range of taxes: property, sales, and income, although you did have to choose between deducting sales taxes or income taxes. You couldn’t claim a deduction for both.
That’s still the rule, but now there’s an overall limit to how much you can deduct. It caps out at $10,000 under the terms of the TCJA. If you pay $6,000 in property taxes and $5,000 in income taxes for a total of $11,000, you’ll lose $1,000 of that deduction beginning in 2018. You can either claim $5,000 in property taxes or $4,000 in income taxes, but that other $1,000 for the full $11,000 you paid is no longer available. This will be a real blow to those who live in states with high income tax rates or areas with high property tax rates, such as New York, New Jersey, California and the District of Columbia.
And if you’re married and file a separate return, you must cut that $10,000 figure in half. These filers are entitled to only a $5,000 deduction in state, property and local taxes. This rule doesn’t apply to single or head of household filers, however—they can claim the full $10,000.
Foreign real property taxes can’t be deducted anymore, either. The TCJA eliminates that tax law provision.
Can You Prepay Your Taxes to Get the Old Deduction?
This aspect of the new tax bill had many taxpayers storming their local property tax assessment offices at the end of 2017. hoping to prepay their 2018 taxes so they could still claim a deduction for the full amount. But on December 27, 2017, the Internal Revenue Service effectively said, “Not so fast.” If you did prepay your 2018 property taxes in December, they’re only deductible in 2017 to the extent that they were already assessed. In other words, you actually received a bill for your 2018 taxes—and paid them—before December 31, 2017.
You can’t claim a 2017 deduction for what the IRS has called “anticipated” 2018 taxes.
The Deduction for Home Mortgage Interest
This deduction hasn’t been eliminated either, but it’s suffered. It’s more restricted now, but to be fair, many taxpayers won’t feel the bite. Only those who can afford particularly sizeable mortgages will be affected.
Through 2017, you could deduct interest on mortgage loans of up to $1 million if they were used to acquire a first or second residence, or $500,000 if you were married and filed a separate return. You could also deduct interest on home equity loans of up to $100,000. The TCJA cuts this to acquisition loans topping out at $750,000, or $375,000 for married taxpayers filing separately, and you can no longer deduct interest on home equity loans.
In other words, unless you can qualify for a $750,000-plus mortgage, not much changes for you.
The applicable dates aren’t as clear cut with the amendments to this deduction. The old $1 million limit doesn’t quite last until December 31, 2017. It applies only to mortgages contracted for before December 14, 2017, and you must close on the property by April 1, 2018.
And here’s another wrinkle: You can refinance an existing mortgage that you took out before December 14 in tax year 2018 or later and you can still deduct the interest, but only if the refinanced amount isn’t greater than your old loan balance. Remember, the deduction for interest on home equity loans has been eliminated, but if you’re not taking any cash out, you’re fine.
Deductions Affecting Workers
The TCJA also eliminates two advantageous deductions for the working class. It used to be that you could deduct certain moving expenses if you had to relocate for work-related reasons, subject to several qualifying rules. Hopefully, you moved before December 31, 2017 or you can hold off on doing so until the TCJA expires in 2025, because this deduction is no more.
Technically, this was an above-the-line deduction, an “add-on” to your itemized deductions or your standard deduction. And this change does not affect active duty military personnel. They can still claim this deduction when and if they’re forced to move for service-related reasons.
Those miscellaneous itemized deductions you used to be able to claim for expenses you had to make for work-related purposes are gone, too. Some miscellaneous deductions have survived the TCJA, but not this one. On the bright side, these were only deductible to the extent that they exceeded 2 percent of your AGI anyway, and if they were not reimbursed by your employer.
The Casualty and Theft Losses Deduction
The casualty and theft losses itemized deduction survived…sort of, but it’s been pared way back. Beginning in 2018, you can only claim this deduction if you suffered a loss due to a federally-declared disaster. The U.S. President must cite the event as a disaster. Fortunately, this covers most catastrophic events like hurricanes, but you’re out of luck if your neighbor steals your brand new laptop.
No More Pease Limitations
Charitable deductions are still alive and well and they remain unchanged, and here’s a bit of good news. This deduction—as well as the home mortgage interest deduction—was subject to something called the Pease limitations through 2017. For those with high incomes, these limitations reduced itemized deductions by 3 percent for every dollar of taxable income over certain thresholds and ultimately up to 80 percent of their itemized deductions.
The TCJA repeals the Pease limitations, so go ahead and donate to your favorite charity no matter how much you earn. You can still claim this tax deduction in full.
The Standard Deduction vs. Itemized Deductions
It might not be all doom and gloom for some taxpayers. Yes, you're losing a handful of itemized deductions and other deductions have been limited. But the TCJA almost doubles standard deductions for all filing statuses: from $6,350 to $12,000 for single taxpayers, from $12,700 to $24,000 for married taxpayers who file jointly, and from $9,350 to $18,000 for those who qualify to file as head of household. So while your available itemized deductions might shrink, your available standard deduction will mushroom, potentially offsetting the loss.
You might find that you come out in much the same tax situation as before, or you might even come out ahead under the new rules. If you and your spouse were historically able to amass $20,000 in deductions, or if your itemized deductions are reduced to under $24,000 in 2018 by the new law, you’d actually lose money by itemizing.
The House-Senate Conference Committee revealed their agreed-upon tax reform package late on Friday, December 15th. As we write this, the Act has not yet become law, but we expect the House and Senate to separately pass it quickly and send it to President Trump shortly thereafter. While the devil is in the details, we wanted to pass along some of the key provisions.
Individual Tax Rates. The Conference bill calls for a maximum individual tax rate of 37 percent, down from 39.6 percent, but did not change the number of brackets as expected. To give you an idea of the changes, here is a 2017 – 2018 comparison for married filing jointly:
Capital Gains Rates. The Conference bill generally retains the present-law maximum rates on net long-term capital gains and qualified dividends: 15 percent and 20 percent depending on income levels.
Standard Deduction and Personal Exemptions. The standard deduction will nearly double in 2018 to $24,000 for joint filers, $18,000 for head-of-household filers, and $12,000 for all other individuals, indexed for inflation for tax years after 2018. However, personal exemptions of over $4,050 per eligible person will be eliminated.
Mortgage Interest Deduction. The Conference bill limits the mortgage interest deduction to interest on $750,000 of “acquisition indebtedness” ($375,000 in the case of married taxpayers filing separately), beginning in 2018. For acquisition indebtedness incurred before December 15, 2017, the current-law limitations of $1,000,000 ($500,000 in the case of married taxpayers filing separately) remain. However, no interest deduction is allowed for interest on home equity indebtedness after 2017.
State and Local Taxes. The Conference bill limits deductions for nonbusiness state and local tax expenses, including property and income taxes, to $10,000 ($5,000 for married filing separately). Moreover, taxpayers will not be able to deduct any 2018 taxes prepaid in 2017 on their 2017 tax returns.
Other Itemized Deductions Under the Conference Bill:
Charitable Contributions. Generally kept the same as 2017 except the deduction for certain contributions is limited to 60 percent of adjusted gross income rather than 50 percent. Also, a deduction will no longer be allowed for contributions made to gain seating rights for college sports.
Miscellaneous Itemized Deductions. Repealed.
Medical expenses. Not only retained but enhanced for 2017 and 2018 in that the threshold for the deduction was lowered to 7.5 percent of adjusted gross income for all taxpayers.
Casualty Losses. Allowed but only for losses attributable to federally-declared disaster areas.
Alimony. The Conference bill repeals the deduction for alimony payments and the inclusion in the income of the recipient, but only for divorces executed after December 31, 2018.
Moving Expense Deduction. The Conference bill repeals moving expense provisions, except for members of the military required to move.
Dependent Tax Credits. The Conference bill increases the child tax credit to $2,000 per qualifying child, up to $1,400 of which may be refundable. There is also a $500 nonrefundable credit for qualifying dependents other than qualifying children. The adjusted gross income threshold for phasing out the credits is increased to $400,000 for joint filers and $200,000 for others.
Alternative Minimum Tax (AMT). The Conference bill keeps AMT for individuals but increases the exemption (to $109,400 for joint filers) and exemption phase-out thresholds (to $1 million for joint filers) to reduce the number of taxpayers subject to it. The corporation AMT is repealed.
Section 529 Plans. The Conference bill enhances Section 529 college savings plans by allowing up to $10,000 of distributions per student during the year to be used for elementary or secondary school.
Estate and Gift Taxes. The Conference bill does not repeal the estate tax as once expected but it doubles the estate and gift tax exemption for estates of decedents dying and gifts made after 2017.
C Corporation Tax Rate. The Conference bill provides for a 21 percent corporate rate effective for taxable years beginning after December 31, 2017. This rate also applies to personal service corporations.
Depreciation Rules. The Conference bill generally increases the 50 percent “bonus depreciation” allowance to 100 percent for new AND used property placed in service after September 27, 2017, and before January 1, 2023. Business passenger automobiles will also be eligible for more favorable depreciation rules. In addition, among Section 179 changes, HVAC equipment is now eligible for Section 179 expensing.
Deduction for Pass-through Businesses. The Conference bill effectively lowers the tax rate for individual and trust owners of certain “qualified” S Corporations, LLCs, partnerships and sole proprietorships by providing a 20 percent deduction on qualified business income. The deduction is limited to 50 percent of the W-2 wages with respect to such business, or if greater, the sum of 25 percent of the W-2 wages plus 2.5 percent of the cost of qualified property acquired during the year. Owners of “specified service businesses” where the principal asset of the business is the reputation or skill of one or more of its employees or owners, such as businesses in the fields of health, law, consulting, and financial services, are generally not eligible for the 20 percent deduction. However, there is a small taxpayer exception to both the wage limitation and the “specified service business” exclusion as both generally do not begin phasing in until owners have adjusted taxable income of more than $157,500 ($315,000 for joint filers).
Small Business Methods of Accounting. Beginning after 2018, small businesses with average gross receipts of $25 million or less will be allowed to use the cash method of accounting regardless if it is a C Corporation or a partnership with a C Corporation partner. Moreover, taxpayers that meet the $25 million gross receipts test are not required to account for inventories.
Revenue Recognition. The Conference bill generally requires accrual method taxpayers subject to the “all events test” for revenue recognition to be in conformity with its “applicable financial statements” if such are prepared by the taxpayers.
Business Interest Expense Limitations. The Conference bill limits the deduction of net interest expense for businesses with average gross receipts in excess of $25 million. The deduction is generally limited to 30 percent of adjusted taxable income (after adding back depreciation and amortization expense).
Corporate Net Operating Losses (NOL). For losses generated after 2017, the Conference Bill limits the NOL deduction to 80 percent of taxable income, disallows most carrybacks, but generally allows indefinite carryforwards.
Business Entertainment Expenses. The Conference bill generally repeals the business deduction for entertainment, amusement or recreation expenses. The 50 percent deduction for business meals is generally retained.
Domestic Production Deduction. The Conference bill repeals this popular deduction.
Affordable Care Act (ACA) or “Obamacare.” The Conference bill repeals the ACA’s individual mandate to buy health insurance by making any required payment $0 beginning in 2019.
Effective Dates. Unless noted otherwise above, the tax changes generally are effective beginning in 2018. Many of the individual provisions “sunset” after 2025 resulting in a reversion to current law unless Congress acts beforehand.