The dust has mostly settled on the tax changes for 2018, and we can identify a number of things you can still do to reduce your tax bill for 2018. Although I make reference to many changes in tax law, this is meant to be a planning tool, and not an exhaustive list of the changes.
Itemized Deductions vs Standard Deduction
Most taxpayers are entitled to the Standard Deduction, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. This has always been the case, but the Standard Deduction has increased substantially in 2018, and fewer people will be itemizing their deductions.
Previously, a single person got an automatic deduction of $6,350, and a married couple filing jointly $12,700. In 2018, though, these amounts are be increased to $12,000 and $24,000 respectively. That’s the good news. The bad news is that your deductible expenses may not do you any good if they fall below the new levels. The other bad news is that many of the expenses that were deductible in the past may either be eliminated or severely limited in 2018.
What You Can Deduct:
Medical expenses – You can deduct medical expenses that exceed 7.5% of your income. These expenses are deducted when they are paid, so you can accelerate or delay payments to maximize your deduction in a given year when you might exceed your standard deduction.
State and local taxes (SALT) – State income taxes, real estate taxes and personal property taxes have always been deductible, but in 2018, they are limited to $10,000 whether you are single or married. This will make a big difference to taxpayers in states with high taxes, but the impact will be reduced for many taxpayers who have paid Alternative Minimum Tax in the past. The common practice of accelerating payment of property taxes is no longer beneficial to most taxpayers.
Mortgage interest – Interest on home mortgages has previously been deductible on loans up to $1 million, and home equity loans up to $100,000. Starting in 2018, for new mortgages, the limit is reduced to $750,000. You can continue to deduct interest on your existing $1 million loans, but the deduction for home equity loans is gone – unless it falls under the $750,000 overall limit, and was used to improve the property. If you refinance your existing mortgage, the old $1 million limit still applies.
Charitable donations – Charitable donations are deductible up to 60% of your income, up from 50% in the past. Any excess can be carried forward to future years. The limit is 30% for gifts of stock, which is discussed later in this article. If your itemized deductions are below the new Standard Deduction, making a larger donation every second year could put you over the threshold in those years.
Gambling expenses, up to the amount of winnings, and investment interest, up to the amount of investment income, are still deductible.
What You Can’t Deduct:
Casualty and theft losses – This deduction has gone away, except for losses in a federal disaster area. You can no longer deduct losses from theft or other casualty losses. The existing income limitations still apply.
Unreimbursed employment expenses – Business expenses for employees (NOT self-employed or 1099 workers) are no longer deductible. These include union and professional dues, education expenses, home office expense, mileage, travel and meals, and other usual and necessary expenses incurred for the convenience of your employer, but which the employer will not reimburse. As I suggested last year, if you have substantial expenses of this nature, you may benefit from a change of status from employee to independent contractor. Also, if your income is relatively high, you should consider forming an S Corporation, as discussed later in this article, and in a separate article on this website.
Investment expenses – Fees paid to investment advisors are no longer deductible. Speak to your advisors to see if they can replace advisory fees with transaction-based fees, which are still deductible.
Legal expenses – Most personal legal expenses previously deductible are gone. Business related legal expenses are still deductible, as are fees related to discrimination lawsuits. Legal fees for divorce or child support are no longer deductible.
Hobby and not-for-profit rental expenses – You still have to report income from hobbies and casual rentals, but you can no longer deduct the related expenses. If you can generate a profit from these activities in some years, though, they could be considered to be for-profit business activities, and you could deduct your expenses in that case.
Tax preparation fees – The personal deduction for tax preparation is also gone. Fees for preparation of business or rental returns are still deductible.
Defer Income / Accelerate Deductions
There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.
If you have business income – self-employed, partnership, etc. – you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year. A very important change in 2018 is the Qualified Business Income deduction. It is discussed later in this article, and should be considered when you are looking at deferring or accelerating income.
If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.
Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.
Alimony will no longer a deductible expense for divorces finalized after 2018, and will no longer be income to the recipient, so try to speed the process or slow it down, depending on your objective.
Alternative Minimum Tax (AMT)
Alternative Minimum Tax has not gone away, but there have been substantial changes, which will result in fewer people paying AMT. The thresholds have been increased, and two of the main causes of AMT, state and local taxes and unreimbursed employment expenses, have been eliminated or severely limited. Incentive Stock Options are still an AMT item, so speak to your tax advisor well in advance of exercising any ISOs, as careful planning could reduce the tax impact.
Take Investment Losses Before Year-End
If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.
Make the maximum contributions to your retirement plans.
You can deduct contributions of $18,000 (more if you’re over 50) to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program. Your employer can contribute up to $18,000 as well.
You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th. Contributions to a ROTH IRA are not deductible, but penalties are much less severe if you have to withdraw funds early.
If you are in an income category where you are not eligible to deduct contributions to a traditional IRA or contribute to a ROTH IRA, consider a “back door ROTH.” You can make a non-deductible contribution to a traditional IRA, then convert it to a ROTH. It sounds a bit tricky, but it is still allowed.
If you’re self-employed or have an S Corporation, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $55,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA, but it must be paid by the corporation, and the amount depends on the W-2 salary you receive from the corporation.
If you have a corporation or partnership, you should also look into a Defined Benefit retirement plan. There are important cost and other business issues involved in the decision, but you could potentially take a deduction of up to $250,000 – substantially more than a SEP IRA.
Don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Before you take an early withdrawal, though, remember that you may be able to borrow from your 401(k), but not from your IRA. There are also penalties for early withdrawal from a ROTH, but your original contributions are not taxed a second time.
You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.
Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.
Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.
Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction. If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT). The limit is 30% of your income, but any excess can be carried forward to future years.
You can make tax-free gifts of up to $15,000 ($30,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $11,180,000.
Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.
Some people, in anticipation of their death, make gifts of real estate or other valuable property to family members. Be sure to speak with a tax advisor before you do this, as an inheritance could have a much more favorable tax benefit to your family member than a gift.
Avoid the “Kiddie Tax”
If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think carefully before you give them stocks to sell to pay for college.
You can deduct 100% of qualifying asset purchases up to $1,000,000 (with phase-outs if your total purchases exceed $2.5 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 100% special depreciation allowance in the year of purchase. These are terrific deductions. If you are planning to buy assets, buy them before year-end, and reduce your taxes for 2018.
Individual tax returns for 2018 are due on April 15, 2019, or may be extended to October 15. Remember that it is an extension to file only, but taxes are still due on April 15. Form 1065 Partnership (including LLC) Returns are due on March 15 (September 16 with an extension), as are Form 1120S subchapter S corporation returns. Single member LLCs do not file Form 1065, so they are due with individual returns on April 15.
There are severe penalties for late filing of partnership, LLC and S Corp returns. For personal returns, there is only a penalty if you owe money.
Form 1099-Misc and Form W-2 must be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year. Remember that Form 1099-MISC must be issued to all individuals and partnerships to whom you paid over $600 during the year. There are penalties for not filing these forms.
The theory is that we are supposed to pay our taxes as we earn the money. This is easy when your employer withholds tax from every pay check, but not so easy for people with self-employment, partnership, S Corp, rental or investment income. That’s where estimated payments come in.
Generally speaking, in order to avoid a penalty, you are required to pay either 90% of this year’s tax by January 15, or 100% of last year’s tax (or 110% if your income is high). There is a quarterly schedule of payment dates, but it would be a good idea to make a payment before the end of the year if you expect to have a high tax bill. The penalty is not huge, but why pay a penalty when you can avoid it?
States have estimated payment requirements, too.
Business Issues – Sole Proprietors, Corporations and Partnerships
There have been substantial changes to the taxation of business income, starting with a reduction of the tax rate on C Corporations to a flat 21%. Corresponding changes were made to income from sole proprietorships and pass-through business entities.
Deduction of Expenses:
Something to consider is that unreimbursed expenses which are no longer deductible for an employee can still be deducted if you change your status to independent contractor, partnership or S Corporation. This change is having a big impact on the entertainment industry, among others.
By the way, entertainment expenses are no longer deductible. This includes such things as tickets to sporting events.
QBI Deduction – This is Important:
There is a potential deduction on your personal tax return of up to 20% of your Qualified Business Income, or income from a trade or business. This applies to income from a sole proprietor as well as a partner with pass-through income from a partnership or a shareholder with pass-through income from an S Corporation.
If your income (excluding capital gains and losses) is under $157,500 ($315,000 if you are married) you will be eligible for the full 20% deduction. The benefit phases out, however, so that there is no deduction when your income reaches $207,500 (or $415,000 if you are married). There are exceptions, though, and this is where planning can make a big difference.
If you are in a Specified Service business, you can’t get any benefit from the QBI deduction after you pass the phase out income range. Specified Service businesses include those related to health, law, accounting, consulting, performing arts and others. Engineering and architecture are specifically excluded from this group, and are eligible for further deductions, as discussed below.
If your business pays W-2 wages, and you are not a Specified Service business, then you can take a QBI deduction of up to 50% of wages paid, up to the 20% maximum. Alternatively, you can use 25% of wages and 2.5% of the undepreciated cost of property used in your business. This also applies to your share of pass-through income, wages and qualified property from a partnership or S Corporation.
Important planning point – As a shareholder of an S Corporation, you are required to pay yourself a reasonable W-2 salary, and this counts toward the QBI deduction. So, if your income exceeds the threshold, and you don’t have any employees, you should consider forming an S Corporation. See a more thorough discussion in another article on this website.
Net Operating Losses:
NOLs can no longer be carried back 2 years, as they have in the past. They must be carried forward, but now only 80% can be carried forward. You may want to look at opportunities to defer some expenses, as discussed earlier, so the full amount can be deducted next year.
Rules for S Corps and Partnerships:
There are very specific rules related to S Corps and Partnerships, and now is a perfect time to be sure you in compliance before year-end. It would be a shame to lose out on the tax benefits of these business entities.
S Corp Salary – If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Speak to your tax advisor about what is considered a reasonable salary.
Retirement plans – As discussed above, there are opportunities for S Corp shareholders and partners in partnerships and LLCs to make very substantial tax-deferred contributions to SEP and other retirement plans. The contributions are a percentage of your partnership income or your S Corp salary. It is important to remember that the retirement plans MUST be in the name of the S Corp or the partnership. Individual shareholders and partners cannot have their own individual SEP plans.
Health Insurance – Your health insurance payments may be deductible on your personal return if you are a shareholder in an S Corp or a partner in a partnership or LLC, and you meet certain requirements. Remember, though, that the payments must be made by the corporation or LLC – or reimbursed if you make the payments yourself. Payments for your health insurance made by your S Corp must be included as compensation on your W-2, but are not subject to payroll taxes. Make this clear to your payroll processing company. Payments by your partnership or LLC are treated as distributions. If you have a single member LLC, you can make payments from your business or personal account.
Do you need your LLC or S Corp? – Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2018 tax bill, but it will cut future costs… See the article I wrote earlier on this website.
I would be pleased to discuss your tax planning issues.