Prepare for challenges and take advantage of opportunities.
In wealth planning, it pays to think ahead. With the goal of gaining greater understanding of tax and wealth planning considerations likely to be particularly relevant this year, experts at Northern Trust have developed a set of forward-looking forecasts. Below, we share their outlook for several 2019 themes and actions you can take to help ensure you are both prepared for challenges and ready to take advantage of opportunities.
Individuals will continue to evaluate their state and local tax burden in the context of their overall tax and financial picture.
State and local taxes are a multifaceted problem. While some people focus on the headline income tax rate and move to a state with either low or no individual income taxes, others assume such states make up for the lost revenue in other ways – e.g., sales and business taxes. The truth often lies in the middle.
The federal tax overhaul has put state and local taxes in the spotlight, with the federal itemized deduction for state and local taxes capped at $10,000 through 2025. When individuals add up their state income taxes or sales taxes and property taxes, this amount can seem like a pittance. The net effect is that many people have lost the ability to deduct state and local taxes for the next six years.
Finally, people are increasingly reading the political and economic tea leaves, with many wondering if state budget deficits and unfunded liabilities are likely to make state and local tax increases inevitable.
Competition among states: Experts disagree about the extent to which taxes drive migration, as there are numerous other factors at play, from cost of living to culture. But data collected from federal income tax returns suggests that people are indeed leaving high-tax states.1
Emphasis on state tax structure: The $10,000 cap on the deductibility of state and local taxes generally applies to individual taxes and not business taxes. States that currently collect more revenue from individual taxes could raise business taxes and lower individual taxes to take advantage of the new federal rules. If so, a cat and mouse game between the federal and state governments might ensue.
Prepare for audit: If you move from a high-tax state, be prepared for an audit with the tax authorities in that state. Detailed records can support your argument that you have exited the state for tax purposes.
Avoid accidental residency: If you have multiple properties, avoid inadvertent residency in high-tax states by being mindful of how much time you spend at non-primary residences.
Businesses of all sizes are analyzing entity selection and conversion after the tax overhaul.
The tax overhaul reduced the corporate tax rate to 21 percent. This change is permanent. In contrast, Congress provided partnerships, limited liability companies (LLCs), S-corporations and sole proprietors temporary tax relief. Owners of these entities enjoy a deduction of up to 20 percent of taxable income if they meet a myriad of eligibility requirements, with the deduction set to expire at the end of 2025.
There also are non-tax reasons to consider one business entity over another. For example, nearly every U.S. state allows a business to incorporate as a social benefit entity, or B-corporation. Board members of B-corporations generally have a fiduciary duty to consider a broad range of social interests as they make their decisions, and not just to maximize corporate shareholders’ interests.
Doctor and lawyer conversion: A University of Pennsylvania study predicts that over 235,000 business owners will convert their business entities from pass-through entities to C-corporations as a result of the tax overhaul.2 Doctors and lawyers are most likely to switch, given that the 20 percent deduction does not apply to services income.
Regulatory backlash: The Treasury Department issued final regulations on the 20 percent deduction the third week of January. Taxpayers who believe that the final regulations are unfavorable to them could decide to convert their business entities.
Remember gain exclusion: The “qualified small business stock” rules have allowed many small business owners to avoid capital gains tax altogether when they sell their businesses. But only C-corporation stock can be qualified small business stock – so the tax forgiveness on exit is only available to C-corporation shareholders, not to owners of pass-through businesses.
Prepare for audit: Entities taxed as partnerships are audited under a new set of federal rules as of January 1, 2018. A single partnership representative negotiates a binding settlement with the Internal Revenue Service, and individual partners have little recourse if they are presented with a tax bill that is unfair. Account for the new partnership audit regime in your choice of entity.
Private equity will continue to be central to an individual’s wealth plan.
In 2002, there were over 6,000 companies publicly listed on the U.S. equity markets. By 2017, that number had dropped to 5,187. Companies that were public have decided to go private, and companies that are private are increasingly deciding to remain private. While the reasons are complicated, they include concerns regarding: activists; frivolous shareholder litigation; short term returns over long term growth; and cost and regulatory fatigue.
For individuals, the trend toward privatization manifests in two ways. First, family businesses more often remain in the family. Second, private equity funds and real estate funds feature prominently in individual portfolios.
Access: Many commentators have expressed concern that, if the fastest growing companies are private, small investors will not be able to purchase their shares. That said, we may see more syndicated private investment funds that allow investors to access this asset class with lower investment minimums.
Tax complexity: Private investments create income tax complexity. Partnerships usually do not report tax information to investors until well after the April 15 individual income tax filing deadline. So private investors must put their federal and state tax returns on extension until Forms K-1 are issued. The timing and character of tax distributions from partnerships also can be unpredictable, and partnerships without tax distribution provisions can create phantom income. In both cases, investors can find themselves without the liquidity they need to cover a surprise tax bill.
Take advantage of valuation: Private holdings may be discounted for lack of control or marketability, among other reasons. These lower valuations potentially mean that you can transfer the asset to your beneficiaries during life or at death with a reduced gift, estate and generation-skipping transfer tax cost. If you would like to transfer assets to family or friends, consider which assets will give you the best transfer tax result. And be mindful of investor qualifications associated with any transfers.
Manage liquidity: Cash flow planning is the heart of personal finance. Private investments can be illiquid and can generate current tax bills without corresponding cash. Work with an investment advisor who is mindful of unconventional cash needs.
For more insight into trends and developments likely to influence wealth planning in 2019, read Northern Trust's 2019 Wealth Planning Outlook.
- The Internal Revenue Service collects U.S. migration data based on year-to-year address changes reported on individual income tax returns. It is available at: https://www.irs.gov/statistics/soi-tax-stats-migration-data.
- Penn Wharton, Budget Model, available at: http://budgetmodel.wharton.upenn.edu/issues/2018/6/12/projecting-the-mass-conversionfrom-pass-through-entities-to-c-corporations.