Final reconciliation bill has the votes right now so it’s time to count the bullets we dodged and the opportunities that lie ahead for everyone who works with wealth.
Until the last minute, I didn’t really believe Congress had the will to hammer out a package that could get all the votes they needed to pass. Even now, there’s always a chance that a disastrous last-minute analysis of the economic impact could kick the ball to next year.
But now I think it’s really going to happen. They need to get this one signed and legalized before they can turn to another short-term budget fix and go home for the holidays.
The budget’s a hard deadline. If taxes drag too far out into the week, they’re up against leaving Washington in a state of shutdown. So it’s time to vote and move on.
What they’re going to vote on opens a lot of planning doors for 2018 and beyond. Advisors and their clients can take advantage of many of the same ones, so a little knowledge now can easily turn into both professional and personal gains.
Sore spots are gone, bright points remain
Start with what we were all dreading: the “first in / first out” capital gains treatment the Senate threatened to force on investors in order to claw back a measly $2 billion a year.
FIFO has vanished from the final bill, gone back to wherever half-baked ideas go. That’s a big relief — while a few fringe tax management strategies were emerging to cope with the headaches, it’s easier on everyone to revert to the status quo.
Either way, since long-term capital gains rates aren’t changing, whatever you did in the past to harvest tax losses and generate a better after-tax return, keep doing it. With the high-tax income brackets only moving a little, every short-term loss you can balance against those short-term gains is still valuable.
The brackets themselves are what they are. Now for the exciting part.
It’s worth reclassifying income as deriving from your stake in some sort of pass-through business structure — an S corporation, partnership, LLC or solo proprietorship.
As an individual employee, you simply owe a slice of your income to the IRS. But when you contribute your labor to the business and take the profit out of the back end, Congress will let you deduct 20% before taxes apply.
Pay yourself $150,000 in the coming tax year? Run it through a pass-through structure, deduct $30,000 and save $6,600 in tax (married filing jointly).
There was some debate over whether this deduction would apply to “service businesses” like wealth management, law and medicine. Consensus now says it does — up to gross income of $315,000 for married couples.
After $315,000, thresholds start kicking in -- the business won't be able to deduct more than 50% of its overall income, more or less -- but compared to earned income it's still extremely attractive.
This means there’s real money in operating as a small business. You can still charge “employers” as though you were an independent contractor, but as long as the bills go to the entity and not to you personally, you effectively get a pay raise of up to $15,000 a year.
Unless the benefits you get from working directly for the firm are worth more than that, there’s not a lot of financial sense in not breaking away.
I think we’ll see a lot more breakaway brokers in the new year. They’re basically going to be free agents, sometimes acting as lone wolves and in other circumstances indistinguishable from salaried employees unless you compare the tax returns.
Given the streamlined tax profile, the professional partner can also undercut rival firms that rely on the old employee model. Partners can pay themselves more and charge clients less. If this lasts, the drag will become apparent down the road.
And if you make too much to get the deduction, look into ways to defer compensation until a light year changes the math. Or roll some of the activities that push you over the top into a trust or other vehicle — businesses owned in get the 20% deduction too.
Grab it while you can
Trusts can also be useful if you’re in a high-tax state and smarting from rollbacks on the amount of local tax you can deduct. Ways highly compensated people can reduce the state burden are going to be increasingly important for the next few years.
Because trusts can cross state lines, it’s possible to move income-producing assets to a no-tax jurisdiction and eliminate the drag. In theory this opens up incentives to invest — through a trust — in firms based wherever the tax rules are most favorable.
Of course these breaks are currently set to disappear in 2025, and may be gone earlier if the mood swings on Capitol Hill next year.
But in the here and now, they’re here to be grabbed. Every year you’re saving money in the tax code we have is a year you’re getting ahead of the game. When the code changes, you can turn.