Tax planning is a year-round analysis. However, year-end tax planning is an especially important time for taxpayers, along with their advisors, to take advantage of any opportunities before the year closes. This year is particularly important since the December 2017 tax overhaul created by P.L. 115-97, also known as the Tax Cuts and Jobs Act, (“TCJA”) has shaken up some aspects of traditional tax planning. CPAs and financial planners can play a key role helping taxpayers understand the changes, and conducting the appropriate analysis to determine the right course of action.

Addressing the $10,000 SALT Deduction

One common tactic is to pre-pay the fourth quarter estimate for state income taxes before the end of the year, as it may provide some taxpayers a Federal tax benefit. However, not everyone can leverage pre-payment of state income taxes for benefit because of the Alternative Minimum Tax (AMT). Even in this case, when the AMT eliminates that particular benefit, some taxpayers can receive a Federal tax benefit because of the state income tax deduction allowed for Net Investment Income Tax (NIIT) purposes. Although the state income tax deduction for NII was not expressly addressed under the TCJA, it is reasonable that the new $10,000 limit applicable for itemized deductions applies for NIIT. Section 1411(c)(1)(B) addresses “deductions allowed by this subtitle, which are properly allocable to such gross income or gain,” which would include a reasonable amount of state income taxes. Section 1411 falls under Chapter 2A of Subtitle A – Income Taxes; it is very unlikely that NII would be allowed a deduction that is higher than permitted under Subtitle A - Income Tax.

State income and property tax payment planning under the new $10,000 SALT deduction will require advisors to adopt a different perspective. For example, CPAs and financial planners should consider reviewing real property tax deductions, which fall under that $10,000 limit. Rental properties and sole proprietors with personal and business use should revisit the business use percentage, which does not have the $10,000 limit. If these percentages have not been reviewed for years, now is a wise time to revisit. Additionally, taxpayers who hold vacant land should consider capitalizing their property taxes under Treasury Regulation §1.266-1(b), provided that they are not receiving an itemized deduction for the year.

Charitable Giving

The Tax Cuts and Jobs Act of 2017 also changed the landscape for charitable giving. Tax professionals may encourage clients to itemize for some years and not others (for example, every other year), to take advantage of the near doubling of the standard deduction. Taxpayers will be accelerating deductions into a single tax year in order to itemize. A Donor Advised Fund (DAF) can be used to “smooth” the charitable distributions so as not to disrupt the benefitting organization.  DAFs can provide a current deduction now when funded, and then charitable distributions can be made later over time. Taxpayers are usually delighted by the planning, and may follow up with their advisor about using this vehicle to make a payment for a pre-existing pledge they have over time. Using DAFs to make payment of a pre-existing pledge may now be permitted with some restrictions according to an IRS Notice that announces potential proposed regulations on this point (see IRS Notice 2017-73). Advisors should disclose these requirements with clients and confirm that the sponsoring organization could permit this type of distribution. If it cannot, advisors should suggest using other sources for payment of the pledges.

The increase of the standard deduction also reinforces another powerful tool in the advisors’ toolbox: Qualified Charitable Distributions (QCDs). Taxpayers who are subject to Required Minimum Distributions (RMDs) from their IRAs and who are 70 ½ or older may pay the RMD directly to a qualified charity. Taxpayers may contribute up to $100,000 annually, even if their RMD is less than $100,000 for the year. When the payment is made directly to the qualified charity, it will not be included in the taxpayer’s gross income. The QCD is not included in income; therefore Adjusted Gross Income is reduced by the QCD, bypassing the larger standard deduction hurdle.

QCDs can also be made from SEP IRAs and SIMPLE IRAs, other than ongoing SEPs and SIMPLE plans; this is when the employer did not make a contribution to the employee’s IRA for the year. The QCD directly reduces Adjusted Gross Income, which is tied to many other deductions and credits, making this tactic particularly powerful. The Form 1099-R will not disclose that it is a QCD as there is no distribution code, so CPAs will need to confirm with their clients and the receiving organization. Once the QCD is confirmed, CPAs will note the QCD on the Form 1040 itself, by entering “QCD” on the IRA distribution line. In contrast to DAFs discussed earlier, an IRA making a QCD may be used to make payment of a pledge (see IRS Notice 2007-7, Q&A 44).

Using the Section 199A (20%) Deduction for Roth Conversions

The TCJA will require tax professionals to continually evolve their understanding of many of the law’s nuances. One concept to consider is the acceleration of ordinary income in order to receive the 20% deduction on Non-Qualified Business Income. This strategy strives to take advantage of the mechanics of the Section 199A deduction.

In general, the Section 199A deduction will provide a deduction equal to the lesser of:

• Combined Qualified Business Income; or
• 20% of the excess of taxable income over the net capital gains

Section 199A may permit a deduction for business income of some sole proprietors, S-Corporation shareholders, and partners (including Limited Liability Company (LLC) owners). The deduction is restricted to that of the individual’s income which is actually taxable that year, while carving out capital gains from the taxable income. With this restriction, the 20% deduction is not a flat 20% of the business’ income, but individuals have to also consider how much taxable (ordinary) income the taxpayer has, while also considering the business’ wages and capital at higher taxable incomes.

Example: Joe has a sole proprietorship and files jointly with Mary. His net income from his sole proprietorship is $100,000. Joe would take a Section 199A deduction for the lesser of:

• $20,000 (QBI of $100,000 x 20%), or
• $15,200 (($100,000 - $24,000 (standard deduction)) x 20%)

The Section 199A deduction is limited, and as a result of that limit, taxpayers could potentially consider recognizing more ordinary income, while paying tax on only 80% of that additional income. Now, similar to running two projections, one with and the second without pre-payment of state income taxes, CPAs and financial planners may instead be running two projections that project how much additional ordinary income (such as from Roth conversions) may be recognized, before the Combined Qualified Business Income is used for Section 199A. Using our fact pattern above, Joe could theoretically do a Roth conversion of $23,995 and receive a Section 199A deduction of $19,999 (($123,995 – 24,000) x 20%). The additional $4,799 of deduction would reduce Joe’s taxable income and yield a benefit of over $1,000 (assuming a 22% tax rate). In short, ordinary income can be used strategically in the context of the Section 199A deduction.

Qualified Opportunity Funds (QOF)

This is a new tax deferral mechanism for capital gains under the TCJA. In general, a taxpayer can reinvest a capital gain within 180 days of the capital gain sale into a QOF. Once in the QOF, tax on the original gain must be recognized on the earlier of the disposition of the QOF or 12/31/2026. There is also an added sweetener to this deferral strategy if done within the next couple years. If the investment is held for five years, then the basis is increased by 10%, and then a total of 15% if held for seven years. Taxpayers will pay tax on 85% (100% - 15% increase of basis) of their original gain that was reinvested. If the reinvestment is held for 10 years, then the investor can elect for their basis to equal the fair market value when disposed, which would essentially eliminate the gain on the subsequent disposition of the QOF.

Proposed regulations were released this October and provided special rules for pass-through entity owners to consider. If a partnership, for example, has an eligible gain that it does not elect to defer, then the individual partner may elect deferral on his or her distributive share within the 180 day period beginning on the last day of the partnership’s taxable year (see Prop. Reg. §1.1400Z-2(a)-1(c)(2)(iii)(A)). This would permit a taxpayer to make their reinvestment as late as June of 2019, assuming the partnership is a calendar year taxpayer. Year-end planning meetings that address large capital gains from partnerships should include a discussion of QOF investments for tax deferral and basis step-ups.

In Conclusion

The December 2017 tax overhaul has changed year-end tax planning. While most CPAs will still be advising on fourth quarter state income tax payments and running their projections, the new tax law provides an opportunity to look beyond traditional planning techniques. The year-end is an optimal time for advisors to develop their strategies even further, as we approach the first full year with the Tax Cuts and Jobs Act overhaul.

David M. Barral, CPA/PFS, CFP, is a 2^nd Vice President at Northern Trust in New York City and an adjunct professor at Wagner College, Staten Island, NY. He also serves as the current chair of the NYSSCPA’s Personal Financial Planning Committee. He can be reached at dmb21@ntrs.com.