On November 2, 2017, the Republican leadership in the House of Representatives unveiled their tax reform proposal. This tax reform proposal, if enacted, would be the most sweeping piece of tax legislation since 1986. Because the actual bill is over 400 pages long, we will be covering several major aspects of it over several blog posts rather than all at once.
If you heard nothing else about the proposed tax reform, you heard that the tax rates that apply to individuals would be decreasing. That is true, although not as straight-forward as it sounds as we will be discussing here and in future posts.
Under the proposal, there would be 4 ordinary income tax rates: 12%, 25%, 35%, and 39.6%.
For single individuals, the 12% rate applies to your first $44,999 of income. The 25% rate applies when your income is between $45,000 and $199,999. The 35% rate applies when your income is between $200,000 and $499,999. All income above $500,000 is taxed at a 39.6% rate.
For married couples filing jointly, the 12% rate applies to your first $89,999 of income. The 25% rate applies when your income is between $90,000 and $259,999. The 35% rate applies when your income is between $260,000 and $999,999. All income above $1 million is taxed at a 39.6% rate. For married couples choosing to file separately, the tax brackets are one-half of the filing jointly tax brackets.
While this proposal does not change the current capital gains tax rates (i.e. 0%, 15%, and 20%), it does change the income thresholds at which the various rates apply.
For single individuals, the 0% capital gains tax rate applies if your income is less than $38,600. The 15% capital gains rate applies if your income is between $38,600 and 425,799. The 20% capital gains rate applies if your income is $425,800 or above.
For married couples filing jointly, the 0% capital gains tax rate applies if your income is less than $77,200. The 15% capital gains rate applies if your income is between $77,200 and $478,999. The 20% capital gains rate applies if your income is $479,000 or above.
For married couples filing separately, the 0% capital gains tax rate applies if your income is less than $38,600. The 15% capital gains rate applies if your income is between $38,600 and $239,499. The 20% capital gains rate applies if your income is $239,500 or above.
Under the House Republicans proposal, business owners may also benefit from a lower tax rate. Businesses that are operated as a sole proprietorship, partnership, limited liability company (LLC), or an S-corporation currently do not pay federal income taxes themselves, but instead “pass thru” the income and losses to the owners. The owners then pay taxes on that business income at their individual tax rates. Under this proposal, owners of these “pass thru” entities would still report the business income on their individual tax returns, but now may pay a maximum tax rate of 25% on a portion of their business income, if they qualify.
All income from passive activities (e.g. a business that you invest in but have no active role in operating) would be taxed at the 25% rate. However, if you are actively operating a business, the government does not want you to disguise your compensation (which may be taxed at a higher rate depending upon what your taxable income is for the year) as business income. Therefore, they apply a formula to determine what percentage of your business income should qualify for the 25% business tax rate. They do allow a safe harbor percentage of 30%, and also allow taxpayers to make a “facts and circumstances” determination rather than using the prescribed formula.
However, certain types of businesses do not qualify for the 25% business tax rate. These businesses are those in the fields of: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation or skill of one or more of its employees. These businesses are typically thought of as “personal services” businesses.
In the next post, we will be discussing changes to the standard deduction, itemized deductions, and personal exemptions and how those changes will affect your taxable income.