In IR-2016-139 (10/25/16) for tax year 2017 the following new IRS tax rules apply:
1) Standard Deduction:
Singles: $6,350 (2016: $6,300)
Married: $12,700 (2016: $12,600)
2) Personal Exemption
Singles: $4050 (2016: same)
This exemption is subject to a phase out and is reduced by 2% for each $2500 of Adjusted Gross Income over threshold AGI levels, as follows:
Single over $261,500 (phased out at $384,000);
Married over $313,800 (phased out at $436,300)
The phase out of may add as much as 1.05% to marginal tax rates.
3) Itemized Deductions
These deductions are reduced by 3% of Adjusted Gross Income (AGI) over $287,650 for singles, $313,800 for married couples filing jointly and are fully phased out for Single Taxpayers at $418,400 (2016: $415,050) and Married Taxpayers at $470,700 (2016: $466,950).
The itemized deductions are reduced by 3% of adjusted gross income not to exceed 80% of total itemizations (medical expenses, investment interest deductions, and casualty losses are all exempt).
The phase-out in itemized deductions is based on the amount of AGI and net taxable income (ie. what is left after itemized deductions). The phase-out in itemized deductions may add up to 1.19% to marginal tax rates.
4) Alternative Minimum Tax Exemption
Single: $54,300 (phase out begins at $120,700)
Married: $84,500 (phase out begins at $160,900)
5) Foreign Earned Income Exclusion:
Single $102,100 (up from $101,300/2016)
Decedents who die during 2017 basic exclusion amount is $5.49m/Husband and Wife $10.98m (up from $5.45m/$10.90m/2016)
In addition Federal Payroll Tax planning (FICA/Medicare) has become more complex as these tax rates continue to increase.
In 2017, the Social Security Tax (“FICA”) aka Old Age, Survivors and Disability Insurance (OASDI), taxable wage base (on which the 7.65% tax is computed i.e. FICA 6.2%/Medicare 1.45%) increased from $118,500 (2016) to $127,200 (2017). This $8700 increase in the taxable wage base is more than double most previous wage base increases.
The maximum 2017 OASDI portion of the Federal Insurance Contributions Act (FICA) tax is payable by each employee and is $7886 (6.2% of $127,200/2017 taxable wage base);the Medicare tax is 1.45%(with no wage tax base ceiling). In tax year 2017, the first $127,200 would have a Medicare tax of $1884.
For 2017, the total payroll tax for employees (FICA/Medicare) is $9730. For employers of closely held companies who pay themselves a salary the Employer/Employee combined tax is $19,460.
The taxable wage base in excess of $127,200 remain subjects to an unlimited 1.45% Medicare tax on wages. For taxpayers whose wages are over threshold amounts ($200k/individual & $250k husband and wife) there is an additional 0.9% Medicare tax on earned income (which is in addition to 3.8% Medicare tax on investment income); the tax is then 2.35% so high earners who have closely held companies pay an additional combined 4.7% tax.
Tax Planning Strategy (Closely Held Companies)
To the extent possible, investment income (as compared to wages/earned income) should not be paid out as wages (by the owners of closely held companies). Otherwise the wages are subject to $19,460 in Social Security Taxes (Employer/Employee share) and Medicare taxes up to 2.35% (4.7% Employer/Employee share).
Instead, consider segregating investment assets into a CA limited liability company owned 99% by an S-Corporation, which is also the Manager (and 1% by a California Revocable Trust, which trust owns the S-Corporation /100%).
In this scenario, the LLC receives the investment earnings, distributes net income (after expenses) to the S-Corporation (99% Member/ Manager). The S-Corporation may allocate a portion to salary, fund a profit sharing or defined benefit plan creating a “tax-shelter for the investment earnings” or make a net distribution (after payment of a reasonable salary to officers) as S-Corporation income to the S-Corporation Shareholders (S-distributions do not have payroll taxes due).
This tax planning has both income tax and asset protection benefits as follows:
1. Unlike an LLC, S-Corporation distributions do not have payroll taxes imposed, which saves $19,460 on $127,200 of S-distribution (as well as a combined 4.7% on distributions received by S-shareholders in excess of the $127,200);
2. The S-Corporation may shelter LLC distributions from tax by making profit-sharing plan/pension contributions in allowable amounts based on salaries (with the excess over salary available as an S- Distribution);
3. Tax audit risk is reduced eg. IRS audit risk is approx. 1% for all taxpayers (and higher for taxpayers who earn more income). The IRS audit risk for S-Corporations is approx. 4/10 of 1% so an S- Corporation has a much lower risk of audit. At the highest income levels i.e. over $1m IRS audit risk is over 10%, over $5m is nearly 20%, over $10m is nearly 35%.
In addition the California/US Income tax “blended tax rates for wage earners is nearly 52% (Federal Tax Rate 44.3% with Medicare taxes; California tax rate: 13.3%); this 51.7% tax rate applies to wage earners.
For investors, the top rate on net investment income is 50.92% (Federal Tax Rate: 43.4%; California Tax Rate: 13.3%).
For taxpayers the phase-outs for personal exemptions and itemized deductions may increase the “blended tax rates” to up to 55%.