The Tax Cuts & Jobs Act (TC&JA) signed into law at the end of 2017 is the most significant tax legislation since the Reagan tax cuts of the 1980s. That being said, the major provisions affect individuals and businesses much more than investors per se.
The 2008 legislation, which introduced new cost-basis reporting requirements for both brokerages and individuals regarding securities, for example, was much more impactful for investors than this new law. Still, there are some changes that investors need to be aware of, which is the subject of this article. The major changes (in my opinion) that may affect a broad swath of investors are as follows, by topic:
Note that this article excludes discussion of TC&JA effects on traders who have established a trading business, and are reporting trading activity as a business, and possibly have elected Section 475 Mark-To-Market Accounting. Like all businesses, the TC&JA can have a major impact on a trading business.
All miscellaneous itemized deductions that when aggregated exceeded 2% of Adjusted Gross Income (AGI) that were previously deducted on Schedule A have been suspended, beginning with tax year 2018. While there are 15 or so investment expenses listed as being potentially deductible, the one that usually matters most is investment management fees. Others are IRA fees paid separately, subscriptions to investment services, safe-deposit box fee if used to hold securities, and accounting fees for a bookkeeper to track investment income, to name a few.
To benefit from these, the total had to exceed 2% of AGI, and of course the taxpayer also had to itemize deductions. Still, a management fee of several thousand dollars for managing a mid-six figure portfolio is common, and loss of this deduction will affect some investors, possibly eliminating any benefit from itemizing deductions in some cases.
The good news is that the preferential rates for Long-Term Capital Gains were retained, at 0%, 15%, and 20%. Another positive is what did NOT make it into the final law, which was a proposal to require First-In-First-Out (FIFO) treatment for all sales of securities. The ability for an investor to specifically identify the lot being sold has been retained, and most major brokerage trading platforms provide for this identification. The default remains FIFO, unless the investor overrides the default.
What has changed is the method by which it is determined what capital gains rate(s) are applicable for a taxpayer, and also, how the brackets are annually adjusted for inflation.
Note that the total amount eligible for the preferential capital gains rates is the total of Long-Term Capital Gains, LESS any Unrecaptured Section 1250 Gain, LESS any Collectibles 28% Gain, PLUS the total of Qualified Dividends Income.
The first step to determine the applicable rate, both previously and now, is to determine the taxpayer’s Filing Status, either Married Filing Jointly (MFJ) or Qualifying Widow (QW), Head of Household (HH), or other, which leaves Single (S) or Married Filing Separately (MFS).
Without getting too deep here, the prior law added the total capital gains eligible for the preferential rates to the total other taxable income, and referred to the regular tax brackets for the appropriate Filing Status, and determined how the capital gains income would be taxed, which was either (a) all at 0%, or (b) some or none at 0% and the rest at 15%, or (c) some or none at 0%, some or none at 15%, and the rest at 20%.
The new law establishes separate income brackets for each Filing Status for determining the applicable capital gains rates. Further, these new brackets for 2018 were adjusted for inflation using the chained consumer price index (C-CPI-U) instead of the regular consumer price index (CPI-U). For 2018 only, the regular consumer price index (CPI-U) was used to adjust the basic tax brackets.
Long story short, new brackets for capital gains rate determination were needed because the different methodology caused them to NOT line up with the regular tax brackets. Going forward, all IRS inflation adjustments will use the chained consumer price index for 2019 and beyond, and this change is permanent, not set to revert back after 2025, unlike many of the TC&JA changes. The effect is that the annual inflation adjustments will be less under the chained CPI methodology than under the regular CPI methodology used before the TC&JA.
As for taxes on capital gains, the end result will be similar to what the prior method would have yielded, in that the applicable tax rate(s) for net capital gains will still depend upon the taxpayer’s total income, and how much of that income is composed of capital gains eligible for the preferential rates.
As for why any of this matters, the answer is it probably does not, as far as tax planning goes. As for actually calculating the tax, if not relying on really good software, be prepared for a challenging time working through the new IRS worksheets to come.
The new 20% Qualified Business Deduction (QBD) for sole proprietors and pass-through business entities, namely Partnerships and S-Corporations, was an attempt to provide tax relief to these businesses comparable to the relief granted to C-corps with the reduction of the corporate rate to 21%.
That is, the purpose of the QBD was to give a tax break to small businesses, whether sole proprietors reporting on Schedule C, or owners of businesses via pass-through entities such as partnerships and S-corporations, who report their business income on Schedule E. Note that it is unclear whether the QBD deduction will apply to rental property owners, who also report on Schedule E. Rental property owners will have to await clarification from the IRS.
The QBD is based on the regular income of a business, and excludes investment income, such as capital gains and dividends. It also excludes income from foreign sources. Further, it excludes compensation for services paid to S-Corp owner-employees, and guaranteed payments to Partnership owners. But most significantly, it does NOT exclude passive owners of a business, such as limited partners in a partnership.
It appears at this point that the deduction WILL be available to limited partners of a partnership, including publicly-traded partnerships (PTPs). Note that PTPs are often referred to as Master Limited Partnerships (MLPs). Since many income-seeking investors own shares (units) of PTPs as investors/limited partners, this MAY turn out to be a significant benefit for these investors.
The remainder of this section is focused on the potential for QBD deductions for holders of partnership interests in publicly traded partnerships (PTPs).
As noted, the QBD deduction is based on the business net income from regular business operations. From the perspective of a partnership K-1, it will exclude interest, dividends, and capital gains as shown on the K-1. Partnership distributions will also (presumably) not be considered. Probably the K-1 Box 1, Ordinary Business Income (Loss), will be the starting value for determining the QBD. There will likely be several new boxes on the K-1 needed for the QBD calculation, which will be discussed momentarily. For example, there may need to be an equivalent to Box 1, which omits any foreign income effects.
The QBD starts out at 20% of qualified business income, but is subject to downward adjustment. The first test is based on whether the taxpayer/owner’s taxable income exceeds certain thresholds, per his Filing Status. For filing status Single, the threshold is $157,500. Consider the case of a single person with a partnership interest in one partnership; if taxable income is under $157,500, and the partner’s share of the partnership’s qualified income is $5000, per Box 1, or an alternative box, which excludes foreign income, the QBD will be the full 20% of $5000, or $1000. This is the simplest case.
If the single person’s taxable income exceeds the threshold of $157,500, it gets much more complicated. The next test in the law as defined provides for a Phase-In of a limitation on the QBD if taxable income is above the threshold amount, but not above it by more than a set amount, which in the case of a single person is $50,000.
Continuing with our example of a single person, if taxable income exceeds the threshold of $157,500, but by less than $50,000, the 20% QBD is reduced proportionally according to how far above the threshold $157,500 the taxpayer's taxable income is, in relation to $50,000. If taxable income is $177,500, that would be $20,000 over the threshold, or 40% of $50,000, so 40% of the QBD would be lost, resulting in a QBD of $3000 instead of $5000.
Again, note that the example cited is for a single person. The threshold and set amounts vary by Filing Status.
But wait, it gets worse. If the taxpayer’s taxable income is more than the set amount, for the taxpayer's Filing Status, above the threshold, the QBD calculation becomes much more involved, and requires additional data regarding the partner’s share of the business. Specifically, it must be determined what the partner’s share is of the W2 wages paid by the partnership, AND also what the partner’s share is of the unadjusted basis of depreciable property owned by the partnership. Thus, these items will have to be added to the K-1 in order to figure the QBD for higher income partners.
I will spare the reader the details of how to determine the QBD if this third test comes into play. All this article is trying to accomplish is to focus on the concepts behind the QBD calculation. After all rules are applied, the result can range from a DBD of 20% of qualified business income, a lesser DBD, or even a minimal or no DBD. Like much else in the tax code, benefits evaporate as income increases.
A further twist in calculating the QBD limitation is required if the business is a “Specified Service Business (SSB)”, which is invoked if the taxpayer’s taxable income exceeds the threshold. I will again (mercifully) spare the reader the details, but the good news here is the limitation for SSBs is only applicable for taxpayer’s with taxable income exceeding the initial threshold for their Filing Status.
Unanswered in all this is how to calculate the final QBD if a taxpayer has multiple businesses, which will usually be the case for investors in MLPs, who are often invested in several partnerships. Since the calculation is business-specific, how do you combine results, especially if some businesses have a loss, while others do not? If the net result is a loss, does the loss carry over to the next year, thus reducing the QBD for that year? These questions have yet to be answered. The IRS will have to provide guidance, hopefully sooner rather than later.
One fundamental rule for PTPs has always been that each PTP stands alone, in that, unlike other passive activities, passive losses from a PTP cannot be combined with gains/losses from other passive activities, whether other PTPs, or non-PTP passive activities. The rule has been that losses not used from a PTP can only be used to offset gains from that same PTP in a later year, or used generally only upon a final disposition of all interest in the PTP. Is there likely to be some rules limiting the QBD from PTPs in some way, that no other non-PTP partnerships are subject to? This is unknown at this time.
All anyone can do at this point is speculate and wait for IRS clarification. It could range anywhere from a ruling that PTP limited partners are deemed ineligible for the QBD, to a reasonable set of rules for determining the final aggregated QBD for multiple businesses, with carry-over rules if applicable, and no special rules for PTPs. Stay tuned!
One new provision in the TC&JA that puts the final nail in the coffin of Section 1031 usage by Crypto-Currency traders is the limitation of like-kind exchanges to real property, effective for tax year 2018. Without getting into details, there have been arguments both for and against coin-to-coin trades being treated as Section 1031 “like-kind exchanges,” and delaying gain/loss reporting accordingly. While affecting many regular businesses, and presumably not actually directed at Crypto-Currency traders, the new rule effectively ends the Section 1031 debate for coin traders.
As a tax practitioner, I will be awaiting developments on new rules and interpretations for the TC&JA, especially regarding the new QBD and the ability of investors in MLPs being able to take advantage of the QBD. If I become aware of any major developments affecting the topics in this article, I will post an extended comment detailing what has come out and what it means.
For individuals seeking to learn more about all aspects of taxes and trading and/or investing, I recommend becoming familiar with Green & Company, Inc. Their website is www.greentradertax.com. Green & Co. publishes an annual recap of how the income tax law affects traders and investors, entitled Green’s YYYY Trader Tax Guide, which can be purchased for a nominal sum.
I have mentioned Green & Co. before in prior articles, and have purchased the guide annually for several years now. The 2018 guide, the latest available as of this writing, would be a great place to start to learn more about investor/trader tax topics. The website also has numerous timely articles available on investor/trader tax topics, available as a blog.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Other than as a satisfied customer, the author has no connection of any kind to Green & Company, Inc.
The author is an active Enrolled Agent, since November 2015.